Modern portfolio theory (MPT) was originally conceived to give investors a way to use a set of investment inputs to create an efficient investment portfolio. Michael Kitces, partner and director of research, Pinnacle Advisory Group, says that in the intervening period, many investors have lost sight of how best to use it.
Kitces says the architect of MPT, Harry Markowitz, did not focus on input to the model.
“What he said was, ‘I’m developing a model for you that takes inputs – expected returns, volatility and risk, the relationship between assets – and we’ll tell you how to mix those together to construct a portfolio. But I leave it up to you, the user, to figure out what those inputs should be’,” Kitces says.
“As an industry, I think unfortunately we got a little bit lazy. We took the easy way out and said well, I’ve got a brilliant simple idea – let’s just take a long-term historical average of these numbers, that should be a reasonable estimate, especially if these markets are efficient, that means the market should know this is a reasonable estimate, and we can go forth and construct portfolios.
“And the problem that we found recently, and what I think really was brought home in the GFC, is the fact that these long-term historical averages are actually not very good estimates of returns and risks in any particular environment. It varies much more, in practice, in the real world.
The real world requires a dynamic response
“As soon as we introduce the idea that these inputs could be more dynamic, it means in turn that we can still use MPT, but that our asset allocation needs to be dynamic in response.”
Kitces a says a long-term average-return assumption for term deposits of 5 per cent is clearly nonsensical when the actual return at the time an investor buys one is significantly different from that.
“Why would you assume 5 [per cent] when the bank is paying 3?” he says. “Or if the bank is paying 7, it’s equally ridiculous to say 5 – yet essentially, that’s what we’ve done.”
Kitces says the same concept applies to share markets as well.
He says that MPT is based on expected future returns, volatility and correlations, “but the issue is how do we best estimate what a reasonable expected return, volatility and correlation is for our current environment”.
“From that perspective we’re starting to see a lot of different ways that advisers are adapting and trying to evaluate those inputs better,” he says.
“We see approaches like a more valuation-informed approach.”