Some time after 2008, Lou Harvey, the founder of DALBAR, did an interview with Barron’s. He discussed what had been learned in the 2008 bear market. It’s worth thinking about, especially his advice on what seemed to work. I’ve got some nice excerpts, but you can read the whole interview here.
In your study you point out that in spite of the “catastrophic” losses in 2008 “belief in modern portfolio theory has inexplicably remained strong.” MPT is grounded in the belief that asset classes are “predictably uncorrelated.” Because MPT is no longer good for all seasons you relegate it to one of several things investors need to consider.
Modern portfolio theory was pioneered by Harry Markowitz in a 1952 paper published in the Journal of Finance. It posited the construction of an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. MPT is a principle-based investment strategy whose basic idea is that better returns can be produced if a portfolio’s holdings are diversified among different asset classes. The idea: to take advantage of the varying directions as each asset class fluctuates.
Nothing’s wrong with MPT. It’s how people use it. What is needed is a back-up plan to protect investors when the theory fails. And it will most likely happen again.
The pushback to our latest report has been strong. Who are we to criticize MPT, devised by a Nobel Prize winner? But this is our research and we stand by what we’ve found. I have lots of scars on my back to prove it. And I’m sure that after talking to you I’m going to get more. Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process.
What’s the most important finding in your recent research?
For me the biggest recent issue stems from the 2008 market meltdown that defied many of the core beliefs in the financial community—the core belief that asset classes are not correlated. When stocks go down, bonds go up. So might real estate. By holding a little bit in each basket, the investor will make steadier returns and avoid losses. We found out that all of the methods based on modern portfolio theory worked within a certain range. Outside of that range, they all failed.
I added the bold. I’m not sure that a theory can be said to have worked if it fails repeatedly under extreme conditions, so I differ with Mr. Harvey on that. As another pundit said recently, it’s like having a seatbelt that only fails when you have a crash. Of more practical interest is his observation of what did work for investors.
We surveyed investors who outperformed in the crisis and tried to glean from them points to ensure success.
One I particularly like is to take your portfolio out and parse it out into smaller, purpose-driven components, and treat each component separately. Money you can’t afford to lose should not be put into the stock market, but rather in something else that guarantees repayment. It could be an annuity. It could be high-quality bonds. The approach functions on the different ways investors look at their holdings. You look differently at money you have set aside for a gay old time on the Riviera than you do at the money you use for breakfast tomorrow. Each basket should define the risk one should take in the market.
DALBAR’s always done interesting work and their research on investor returns versus NAV returns is now legendary. Here, Mr. Harvey suggests that investors who outperformed in the crisis were those who divided their money into buckets of differing volatilities. This is a psychological trick gleaned from behavioral finance—just a different way of looking at the same allocation. We’ve written about this before, but his observation suggests that it works in practice, not just in theory.
Best practices seem to suggest a belief in supply and demand rather than modern portfolio theory, and ratify the idea of using volatility buckets for clients.