The 2008 market meltdown placed an exclamation point next to a development long in the making: the downfall of the past half-century’s standard investing roadmap—Modern Portfolio Theory.
Academics and industry players alike have called virtually every key pillar of MPT into question. For example, proponents of behavioural finance reject the assumption, crucial to MPT, that investors are fundamentally rational. The theory that markets are efficient, and the assumptions MPT makes about asset correlations, have also been targeted.
Five industry players explain their positions on MPT and how that view informs their practices.
“MPT makes great sense in theory, but in practice does not work effectively for most investors. It assumes both investors and markets are rational, when in fact they’re driven by emotions like fear and greed—along with a host of other impacts that take the mathematical science of the theory and throw it out the window. I’ve been a big advocate of integrating alternative strategies for close to six years. So the other side of the conversation centres on the vehicles people can invest in that don’t rely on the growth of equity markets or economies or bond markets.”
CRAIG MACHEL, Associate Portfolio Manager and Investment Advisor, Macquarie Private Wealth
“With the advent of behavioural finance, people have begun to question the tenets of MPT. We know people aren’t completely rational, but the theory assumes this and other key facts anyway. The theory also depends on forecasting, and pretty much every study says that on average forecasters are wrong. Yet the entire industry is still built on forecasting. What’s wrong with this picture?”
“We don’t discuss MPT or behavioural finance with clients per se. Our communication strategy centres on client objectives and the cash flows they need to meet them. The question is how to fund these objectives with as little risk as possible.”
TOM McCULLOUGH, President and CEO, Northwood Family Office
“For the foreseeable future—at least the next decade—traditional asset classes and investment strategies are going to be challenged to generate the returns our clients’ financial plans require. We haven’t necessarily given up on the old way, but we’ve incorporated some new approaches to asset allocation.”
“We’re still maintaining a diversified approach, but we’ve incorporated alternative asset classes like infrastructure, commercial real estate and private equity into a lot of our client portfolios because we’ve recognized there’s a low level of correlation between these asset classes and the traditional asset classes. The alternative asset classes have about a 15% to 20% exposure in the overall portfolio.”
SCOTT PLASKETT, CEO, Ironshield Financial Planning
“The criticisms of MPT have some validity, but the benefits of diversification—the theory’s main application—outweigh the problems. When you’re talking about how to manage clients’ money for the long term and protect their wealth, you can still make use of the key aspects of MPT even though some of its other elements don’t hold up in every case.”
“The hurdle for clients is understanding the value of diversification, because when times are really good, it seems like a drag on performance. Advisors have to talk to their clients about why they have these diversified assets. Every time you meet with a client, restate the essentials of your portfolio management philosophy. Explain why they have a diversified portfolio, how they’ve earned their returns, and a little bit about your stock-picking process.”
HILLIARD MacBETH, Director, Wealth Management and Portfolio Manager, MacBeth Investment Management Group at Richardson GMP
“The alternative to MPT is trying to skew client portfolios one way or another based on research or other input—but from whom? That’s the problem: from whom do you get the information that would make you manipulate portfolios in certain directions? It may not be perfect, but MPT is the best baseline we have.”
“If you go outside of the theories endorsed by the industry, you open yourself up to a huge level of liability. The Know Your Client program that establishes the client’s risk profile is done based on MPT as the standard for creating portfolios—the assumptions of MPT are embedded in our regulatory compliance requirements. That’s the biggest problem with going outside of MPT.”
DIRK HOHMANN, President, Hohmann Financial Group Inc.