Weekend Update

At a gathering this weekend I had the good fortune to meet someone who completed an MBA degree in Finance from the University of Chicago a few years ago.  Some of you may remember that the University of Chicago is the birthplace of Modern Portfolio Theory (or M.P.T. for short), and other investing / finance theories such as the Efficient Markets Hypothesis, the Mean Variance theory and the Efficient Frontier model.  These and other theories were more or less ‘rolled up’ and packaged in the form of the Modern Portfolio theory.  Good logic, thought and reasoning by Harry Markowitz, Gene Fama, Merton Miller and Myron Scholes contribute into the dominant method of managing investment portfolios today.  Virtually 99% of the investing retail world relies on it because it works.

But it only works in bull markets.

In 50% of the market environments we experience, bear markets, its flaw is exposed.

At its core, MPT is based on the non-correlation of the various asset classes.  In layman’s terms, when large cap stocks are doing poorly, for example, MPT’s contention is that it is likely that one or more other asset classes will be making gains.  Likewise, when any other asset class is under performing, the others stand a good chance of picking up the slack in the portfolio.


And experience bore this out, as the average annual returns over 90 years of the various asset classes varied from around 4-6% for fixed income, 9-10% for large cap stocks and 12-13% for small cap stocks, depending on the time frame and by what definitions are used. Â While the 2003-2007 bull market is depicted in the slide above, it was the bull market from 1982 through 1999, in which the primary large cap index, the Standard and Poor’s 500, averaged 17% and really moved improved the averages, almost to the point of distortion.

However in the real world, we don’t always get to experience bull markets like the one from 1982 thru 1999. Â We also experience bear markets like the secular bear market we’ve been in since 2000. Â (Secular bull and bear markets run years and even decades, while cyclical bull and bear markets occur within the frame of a secular bull or bear and last months and years.) Â Since 2000, the S&P 500 has average around 1% or so, again depending on the exact time frame and who is doing the measuring. Â Â Sure, we had a cyclical bull market within that secular bear market, but that was easily wiped out with the following cyclical bear market that contained the melt down in 2008 and 2009. Â Note the almost direct, lock-step correlation, the narrow path of variance and the drastically squeezed spread. Â The 290% became all of 15%, an almost 90% drop.


So where has been the dis-connect between MPT and Joe Investor’s 401(k)’s (or other accounts’) real world returns? Many financial professional MPT adherents continually refer back to a popularly cited study called ‘Missing the Ten Best Days’. Different versions and write-ups of this study have come and gone over the years, but the main gist of it is that the authors were trying to promote the worn out investing axiom of ‘Time IN the market beats TIMING the market every time.’ A catchy phrase, but not true. At least not true all of the time.  And if its note true all of the time, well, look what happened to investor portfolios since 2008.

During secular bear markets like the one we are in right now, adhering to that line of MPT thinking can do some serious damage to one’s investments, be they individual stocks, mutual funds or exchange traded funds (‘ETF’s’). And we’re not just talking the occasional bad year for a manager here, such as 2008. We are talking about sustained underperformance, whichi is especially important when compared to the key assumption that almost all pension managers, retirement planners and retirement models have made over the past 30-40 years or more- the assumption of 8%. Specifically, almost every planning model in use over that time frame has either a stated (or sometimes unstated) assumption of averaging an 8% overall return over time.

In his book “Expectational Bankruptcy”, author Frank Troise describes how this has come to be:

Wall Street developed a powerfully efficient sales and marketing mechanism to spoon feed investing to their clients. Investing was reduced to easy quotable clichés: “8% per annum doubles your money every ten years!” Account minimums were driven lower and lower as were fees and transaction costs. Investors began investing in the most esoteric things such as hedge funds, private equity funds, commercial real estate funds, managed futures funds, ETFs that could short the market, and on and on. Soon, “saving for retirement” was an extinct expression in our society. “Preserving” one’s wealth was considered an antiquated expression of a time long gone by. Investors were now empowered by Wall Street with all of the technology they could use to drive the returns of their accounts higher and higher.

…Yet investors had grown complacent in their assumptions regarding risk. For over 15 years investors had gotten used to 10-12%/annum returns in the equity markets. Investors were allowed to participate in alternative investments at alarmingly high levels. The term “sophisticated investor” (legally defined as a person’s portfolio value and/or per annum income), was used loosely to entrance new high net worth clients into alternative investments that they didn’t understand. “Sophisticated investor” had no correlation whatsoever to the investor’s true ability to understand what they were investing in. It just gave the legal department in a Wall Street firm the “out” to sell higher fee products.

Despite completing risk questionnaires attesting to their risk tolerance (which was enough for any compliance department to sign off on as it abdicated the firm’s legal risk back to the client), investors never experienced a 20-40% decline in their net worth. Until 2008 it was always a hypothetical occurrence. Simply put, most folks always assumed they’d at least get their 8%/annum return. And why not…wasn’t that what the institutional community was using successfully for years?

It is my firm opinion that the large demographic changes in the U.S. economy are too large of a headwind for any economic offset to occur to reach this 8% return. This has been highlighted in other papers as the “fallacy of 8%.” I am in good company with other investors far smarter than myself. Warren Buffet has for years warned of the assumptions of the 8%:

Warren Buffett’s Letter to Shareholders: Don’t Expect Double-Digit Stock Gains Over Long Run

Posted By: Alex Crippen | Executive Producer


| 03 Mar 2008 | 12:46 PM ET

Warren Buffett’s just-released annual letter to shareholders features a blistering attack on what he calls the “fanciful figures” of Corporate America’s accounting, especially when it comes to assumptions about pension fund returns.

If a company projects larger returns from investments held by a pension fund, then it can lower its pension expenses and raise it’s “less-than-solid’ earnings.” Buffett notes that the 363 S&P companies with pension funds assume, on average, annual growth of 8 percent.

He then goes through an analysis designed to show that anyone thinking they’ll get that kind of return is not thinking realistically.

Most pension funds have about one-quarter of their assets in bonds and cash, generating about a 5 percent return. That means the remaining three-quarters of assets in stocks need to earn over 9 percent to reach overall 8 percent growth. And that’s after ever-increasing fees.

Buffett points out that the Dow’s annual compounded gain was 5.3 percent in the 20th century .. and it was a “wonderful” century. To match that rate in the 21st century, the Dow would need to close around 2,000,000 at the end of 2099. (1,988,000 Dow points to go, eight years in.)

Anyone expecting a 10 percent annual gains from stocks this century are “implicitly forecasting a level of about 24,000,000 on the Dow by 2100. ” (Buffett suggests you explain the math to any adviser who talks to you about double-digit gains, “not that it will faze him.”)Â

This assumption of 8% is alive and well in our country’s public and private pension plans that have erroneously used this high assumption for years. Public and private pension plans have used this simple rate of return as a given number, and a safe reliable return assumption for their liabilities.

Troise goes on to explain the looming pension crisis in the United States and what it’s implications will potentially be for the U.S. economy. I will base my next blog entry on this pension crisis.

For now however, let’s check in on the comments on MPT and other modern finance topics from Warren Buffett and his partner Charlie Munger from the 2009 annual meeting with Berkshire Hathaway shareholders:

Mr. Buffett: “There is so much that’s false and nutty in modern investing practice and modern investment banking, that if you just reduced the nonsense, that’s a goal you should reasonably hope for.”

Mr. Buffett said he was once asked by a student from the University of Chicago, a hub of modern portfolio theory, “What are we learning that’s most wrong?” To which Charlie Munger turned to his partner Buffett and quipped, “How do you handle that in one session?”

Mr. Buffett on the efficient market hypothesis, the idea that all information is instantly priced into the market: “There’s this holy writ, the efficient market theory. How do you teach your students everything is priced properly? What do you do for the rest of the hour?”

Mr. Buffett on complex calculations used to value purchases: “If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Mr. Buffett on the use of higher-order math in finance: “The more symbols they could work into their writing the more they were revered.”

Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

Mr. Buffett adds: “If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics may be dangerous and lead you down pathways that are better left untrod.”

Mr. Buffett on the persistence of bad ideas in finance: “The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.”

Finally, in a recent conversation I had with Mr. Troise, of SoHo Capital, he recalled a response Mr. Munger, always a little less diplomatic in his answers and prone to speaking his mind than Mr. Buffett, gave the following response to a shareholder question regarding the merits of Modern Portfolio Theory as follows: “We’re not fans of it. In fact, Warren and I have discussed often the benefit to our shareholders of endowing a professorship position at every business school in the country for the sole purpose of study of Modern Portfolio Theory, if for no other reason than to ensure there will always be someone to sell our stock positions to.”

So why do 99% of the financial advisors and CFP’s (Certified Financial Planner) in the U.S. cling to these flawed theories? Maybe the answer can come from the University of Chicago’s Economics Department itself. In his book “The Myth of the Rational Market”, author Justin Fox details how over the years most of the principals involved have qualified and / or vaguely backed off much of the “meat” behind these theories. One even went so far as to say they never meant for MPT to be the “correct” answer in the question of what is the best way to manage investments. Rather, they were asked by people from the financial industry to come up with a method that was A.) able to be mathematically modeled and B.) able to be marketed to the masses.

While paraphrasing and not a direct quote from the book, mainly in the interest of space and time, that was main point.

So again, we are left to ask ourselves if a flawed theory, based on faulty assumptions and on stock market history from 80-100 years ago, and developed as a solution that is not with our outcomes specifically in mind, is something we should bank on.  Most investors, lacking any known alternatives and wishing to spend the least amount of time, critical thinking and effort, become victims of the recency bias we’ve spoken of in the past and simply default to MPT. It worked from 1980 through 1999, and their advisors were telling them it was the correct way and to not question it- to instead bury their heads in the sand more or less and “…be a good long term investor.” (Ever heard that before?)

It’s now been 12 years and investor accounts have averaged nowhere near 8%.  The damage has been done slowly over that time if not suddenly in 2008-2009.

I must say it is particularly comforting knowing we can rely on a disciplined, adaptive strategy that is unemotional and self-correcting. Â It is by nature based on the facts of the present, not predictions, assumptions or market behavior of 100 years ago, nor flawed theories of more recent times. Â As it is based on what is performing now, instead of flawed theories, we named it “Fact-based investing”, Â It is the opposite of almost all Modern Portfolio Theory principles, which makes it somewhat contrarian by nature. Â Being contrarian to the dominant portfolio method of the time is a good thing, and the numbers back us up.

-Eric Volk

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