Nice portfolio, shame about the human running it: James Saft – Financial Post

The problem with Modern Portfolio Theory, the basis for most diversified investment approaches, is that the often irrational human investor in charge is a major point of failure.

In other words, nice theory but shame about the monkey who is running it.

Modern Portfolio Theory, originated by Harry Markowitz in 1952, is the idea that portfolios, by diversifying, can maximize returns for a given level of risk, or volatility. This allows investors to get a higher return than they otherwise would since the assets blended together will give a smoother ride, achieving what is often called the only free lunch in investing. Since different assets perform differently in various circumstances i.e. are not perfectly correlated mixing them together improves results.

The problem isnt with the theory, which won Markowitz the Nobel prize in 1960, but, according to money managers at Newfound Investment Research, with the way it fails to take into account the impact that behavioral flaws and biases can have on how an investor actually does.

In MPT, volatility, how much and how quickly an asset goes up and down in price, is used to measure risk. As shown repeatedly in times of crisis and stress, however, different asset classes have a nasty tendency to become more correlated, to all go down together, at the worst possible time.

This increases the chances that an investor will lose nerve and bail out during extreme market conditions, turning what might be a passing downdraft into a permanent loss.

We often say that risk cannot be destroyed, only transformed. Beyond the free lunch of traditional diversification, most reductions in one type of risk come with increases in other types of risk. For example, holding a higher cash allocation will reduce volatility but will lead to more inflation risk, Corey Hoffstein, Justin Sibears and Nathan Faber of Newfound write in a study.

A significant amount of effort can go into providing an investor with an optimal portfolio under the MPT framework, only to see it discarded before the end goal has a chance of being realized. An investors behavior can be one of the biggest risks facing a successful investing.

Asset class returns are not evenly distributed, and investors, who have difficulty measuring the talent of the people theyve hired to advise them, may face long periods when their investments are not performing as theyd planned.

Investors hate two things above all else: losing money and missing out. The tension between the two, the fear of loss and the fear of doing less well than ones neighbor, drives much behavior in financial markets.

It is psychologically painful to lose money. Psychologists Amos Tversky and Daniel Kahneman demonstrated that losing a dollar is about 2.25 times more painful than gaining a dollar is pleasurable. Holding on during market falls is hard, and looking at a supposedly evenly distributed graph of returns does little to give the average saver comfort.

At the same time, humans are animals who naturally compare what they have to what others get, not just to what they had before. Go to a Wall Street trading floor the day bonuses are announced to see how this works out in practice.

This means that investors are sensitive not simply to how they are doing relative to their goals, but also relative to the Smiths down the street. This fear of missing out, and its flipside, pain at lagging, can cause investors to take on too much or too little risk if they observe the stock market, often wrongly conflated with an index, going up faster than their own holdings.

While volatility stands in for risk in MPT, it doesnt fully drive loss aversion or FOMO (fear of missing out), both of which can drive investors to make costly mistakes.

MPT is engineered for end results but investors exult and suffer minute by minute all along the trip.

A slavish devotion to maximizing return for risk can put an investor into a portfolio she cant tolerate, leading to either selling at the wrong time or getting greedy and buying at the wrong time.

In some ways, all of this simply argues for process and for advice.

Part of the value in having a process is not that it is perfect and always achieves best results but that it can guard against the worst mistakes.

And while that process can certainly be run by a solitary investor, given the right skills, another message here is that a good deal of the value of wealth managers is serving as a guard rail against sudden lurches one way or another.

Low-cost off-the-shelf portfolios work well in theory but are followed less often, perhaps, than ones which also have a hand-holding advisor involved.

(James Saft is a Reuters columnist. The opinions expressed are his own)

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Nice portfolio, shame about the human running it: James Saft - Financial Post