Tuesday, July 27, 2010

Did Investors Learn Anything From 2008's Crash?

Lou Harvey of DALBAR takes on the Gods of Modern Portfolio Theory in a recent Barron's article and lays waste to them:

"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. Just look at the current situation. One could argue that the risks are even greater now than in 2008 because of other potential failures out there. We have changed so little from the 2008 failure. Risks have, if anything, increased because of our unwillingness to face up to our problems. We keep talking about a huge increase in federal debt and how, if this trajectory continues, we could even face a downgrade on Treasuries—something many people still believe to be unthinkable

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."

As a recovering MPT and EMH'er myself I understand the backlash Harvey may generate, his bold stance is refreshing in this industry that has kept a closed mind for a long time.

Scott Dauenhauer, CFP, MSFP, AIF