Swimming Naked

Matthew Tuttle has an entertaining article in Advisor Perspectives on momentum.  And he definitely has some skill in turning a phrase!  For example, when discussing the tension between Modern Portfolio Theory and Tactical Asset Allocation, he writes:

In 2002 and 2008 the investment tide went out. And as Warren Buffett famously predicted, we learned who was swimming naked. Both times, it was the practitioners of Modern Portfolio Theory (MPT).

He also has an interesting theory on why relative strength (momentum to academics) is so little used—or at least admitted to—on Wall Street:

Momentum is the documented tendency of investments to persist in their performance. Stock and bond sectors that outperformed other sectors during a period of time (one month, three months, six months, etc.) tend to continue to outperform. More than 300 academic papers have been published showing that momentum outperformance exists in just about every asset class.

If momentum is such a great strategy, then why aren’t more people using it? Think back a few hundred years, when it was official church doctrine that the Sun and planets orbited around the Earth. That was not considered theory — it was taught as fact. Any other idea, no matter how well supported, was heresy. That is the state of the financial services industry today. It has so much invested in the idea of MPT that if it were proven that it didn’t work, such evidence would be devastating.

He also discusses why MPT appears to work much of the time, but finds these arguments ultimately unconvincing:

The years 2002 and 2008 were not flukes. It is human nature to create bubbles in asset classes that eventually burst. Human beings are ruled by emotions. Greed and ignorance cause bubbles to form, and fear causes them to burst. Until we all become Vulcans, bubbles will continue to form and burst. (Unless you believe that the government can head off bubbles in the future. If you do, I have a bridge in Brooklyn to sell you.)

For Sale to Modern Portfolio Theorists

Source: www.answers.com

Whether you decide to buy the bridge or not, it is clear that MPT has some problems.  Behavioral finance addresses some of these shortcomings, but has been criticized as having no unifying theory of its own.

Here’s my version of a unifying theory: both relative strength and deep value work because they are non-consensus and thus inherently psychologically uncomfortable.  They continue to work because people refuse to take advantage of the excess returns available–it’s just too uncomfortable when you are temporarily out of synch with the market.  Both anomalies are well-documented but—in contrast to what theory says should happen—so far the excess returns have not been arbitraged away.  Unless human nature changes, that situation is unlikely to change.

One Response to Swimming Naked

  1. Ian W. Yeo says:

    I admit I drank the Kool-Aid myself. Hence I’ve dropped the CIMA, CIMC, and CIS designations.