Why it is now obsolete portfolio theory
For the past fifty years most investment strategies have been built upon a concept known as Modern Portfolio Theory ("MPT"), which in simplest terms is a method for using portfolio diversification to maximize returns given a specified level of risk. Although MPT originated in the 1950's and has undergone some minor revisions, it is still practiced in essentially in its original form by a wide variety of financial service providers including stockbrokers, investment advisors, and 401(k) plan managers.
To summarize, the basic tenant of MPT is that there is a measurable and predictable relationship between different asset classes that when blended properly should produce a result that either maximizes return for a given level of risk, or minimizes risk for a desired rate of return. Further, any asset class that entails more risk than U.S. treasury securities (the "risk-free rate") must be expected to provide a higher return than treasury securities as they entail a greater degree of risk. Exactly how much more risk these other asset classes entail, and how much greater of a return they can be expected to provide, is extrapolated almost entirely through historical performance. Even more recent methods of recognizing the random order of those returns, such as Monte Carlo Analysis, are still using historical data in the construction of their algorithms regarding frequency and severity. Therefore, the future accuracy of the values assigned to the various asset classes is dependent upon their willingness to conform to their historical performance.
Therein lies the essential flaw of MPT; if the underlying assumptions regarding known performance relationships between different assets classes are incorrect, than all of the calculations used to quantify future portfolio risk based on those assumptions are to some degree invalid. The extent of the degree to which MPT can fail was observed (and felt) by almost all investors during the 2007 | 2009 stock market meltdown, which for the most part did not discriminate between large cap vs. small cap, value vs. growth, domestic vs. international, and also punished most bonds that were not AAA rated. At the same time almost all real estate investments lost enormous value, the effects of which will be felt for years to come. However, a few assets classes performed relatively well, namely gold, oil, and U.S. treasury securities.
The Failure of Modern Portfolio Theory continues on Page Two
