What Proponents of Modern Portfolio Theory Did Not Tell You?

August 28, 2014

What Proponents of Modern Portfolio Theory Did Not Tell You?

Greetings from Hitesh! It has been a great market through out the August and Nifty Future is up close to 400 points in a month!! It made a low of 7540 on 8^th August and 7940 on 26^th August. This way market changes!! We have been telling you our views time and again and we believe that you can take advantage only and only if your destiny allow you!!

Coming back to the most talked about Modern Portfolio Theory (MPT). It was in 1952 when Dr.Harry Markowitz wrote series of brilliant articles for which he received Nobel Prize in economics. His work is the foundation of MPT

The Basic Theory:-

He said you can reduce overall volatility of your portfolio by diversifying your investments in group of non-correlated assets classes. E.g., if equity value goes down, your diversification in bond and real estate can support your portfolio valuations.

His logic was simple – if you know which company or asset class is going to outperform in future, you can buy that and mint tons of money. But since it is not possible – diversification is the best alternative.

He created a team of Greek Alphabet signs Alpha / Beta / Gamma, Delta to determine the past risk of an investment. When you know past risk – you can combine various asset classes depending on your desired RISK – RETURN Ratio.

Another most important thing they told was – market is perfect!! Whatever is to be known- is reflected in the price of the share.

Though all these ideas appeal to us intuitively, there are four specific assumptions behind them which nobody tells you.

Assumption No.1:-

One of the most important assumptions about MPT is you need to give it a TIME to work. It needs lots of time. Time in Decades……not in years!!

You are not timing the market. You just invest for long term. Just to share an example of S&P 500 – Had you invested in it in 1966, you would have taken 16 years before you made gains and 26 years before you made inflation adjusted gains!!

How many of individual investors can wait for this kind of times? This is more suitable to institutions like Insurance companies and pension funds where 30 years are normal.

Our Observation:-

In 2011, we had studied the Bull cycles of India from 1992 till 2009. We had seen that stocks which moved in1992 did not move in 1994/1997/1999/2004/2009. In every cycle there were different stocks and different sectors which moved up and others did not move or went down further. Moreover, many company vanished in just 3-7 years……how can you invest for 30 years in such a scenario? What about technology changes?

After our study, we are planning our investments for just 3-7 years only. In other words we are timing the market. In fact, we were the first to tell about current bull run way back in 2009.

Assumption No.2:-

They talk about concept of Relative Performance. This is the base of Capital Asset Pricing Model developed by MPT.

It says – if market is down by 15% and your portfolio is down by 12%....you have outperformed the market!! You should hold your stocks and stay invested!! The fund manager will ask for performance bonus when you have lost 12% in absolute measure!!

Our Observation:-

At Destiny Management we do not worry about market and compare our performance in relative term. It is best left to mutual funds and institutional investors. We talk about absolute returns. We are perfectly okay – if we are in loss……but we do not want happy feeling for our loss by comparing bigger losses of other market participants!!

When you accept you have loss – you will find out ways to cover it!! But when you compare with bigger loss – you will have happy feelings and you will not change!! Just think.

Assumption No.3:-

Non Correlation of Local Market V/s. International Market

In 2002, they all gathered to talk about the achievements of MPT in the last 50 years – (1952 – 2002). At that time, the hidden assumption of No-Correlation between US and other market came up. They were considering international asset class as separate asset class and marketing like that. No-correlation between two markets was assumed!!

They were assuming that if US market goes down – International market can go up and you can make money!! Following this theory in 1998 – when all the markets went down together – Long Term Capital Management lost heavily and closed the shop!!

In theory, Markowitz had allowed for correlation to change over time. However, in practice, investors were not ready to time the market!!

Our Observation:-

We all are co-related and it is fatal to assume that you are not co-related. Just take example of Europe crisis and US crisis on our market from 2008 to till date. You will realize the mistake of MPT.

Assumption No.4:-

When you apply MPT – the fund mangers shows you a safe return V/s. return on Equity or return on their fund. Normally they use treasury bills benchmark or fixed deposit rate from a Bank. Most use 8% to 10% benchmark of treasury bills to prove you that by diversifying you can make much better money!!

Our observation:-

It’s all about your assumed rate of return!! It was considered Banks are safe and countries can never go bankrupt!! Look at the past 7 years and you will realize that nothing is safe….bank can close and country can also go bankrupt!! There is nothing like Too Big To Fail!!

What is a Way Out?

Mr.Buffett was the first guy to write off this theory and if you read his annual letters – he has criticized them for the above assumptions.

He follows simple theory – Invest in good businesses which you understand at a reasonable price with a moat around it.  He also says – buy when everybody sells and sell when everybody buys!!

Read above line as many times as you can – and you will understand why he is so successful.

My Personal Call:-

The purpose of this article was to educate my reader with the most talked about concept and its hidden assumptions. Most of the normal investors gets carried away by presentations by mutual funds guys and lose their money.

Many of investors (not following my advice) had invested in SIPs – based on the high sounding presentations of mutual fund guys!! During 2008 to 2013 – they realized that More they invest – more they lost!! So, they learned hard way. Free advice can be fatal to your financial health.

If you are my regular reader, you would have realized that I belong to Buffett camp. I follow his way of investing.

If you also want to make money with peace of mind – I suggest you join me.

In case you are interested, do contact us.

Follow me on Twitter @hiteshmparikh Or on Whatsapp - +91-9869425399.

Live With Passion…Invest With Passion.

Hitesh Parikh.