Modern_Portfolio_Theory

Modern Portfolio Theory

Paul Durso Finance 101, Income Planning, Insight Investing Articles, Investing, Investing & Planning, Risk Management

You may have heard of Harry Markowitz, the Nobel Prize winner who developed the Modern Portfolio Theory (MPT). His theory has been widely adopted by the financial services industry as the “go-to” investing philosophy. If you have ever heard of a stock-to-bond mix of investments, then you have heard of MPT. In a recent interview with ThinkAdvisor 1 , Professor Markowitz had some interesting comments and opinions and some of the more interesting ones are shared below.

How about artificial intelligence, as in robo-advisors?

Professor Markowitz says that “Artificial intelligence — quote-unquote — is artificial idiocy.” He states that “there’s no magic elixir that somehow the Sorcerer’s Apprentice is conjuring up mysterious intelligence. It’s a [computer] program!”

Also, in the interview, Markowitz discusses MPT, the vagaries of securities investing, and the reason he essentially moved his investments into all equities when hurricanes hit the U.S. in 2017.

In 1952 Markowitz wrote a paper he called “Portfolio Selection.” The contents would become known as Modern Portfolio Theory as named by analyst Barr Rosenberg.

His article, published in the Journal of Finance in March 1952, showed diversification — that is, the use of uncorrelated asset classes and other considerations — as a way to invest optimally while reducing risk. In 1959, he expanded the theory into a book, “Portfolio Selection: Efficient Diversification of Investments.” The theory has become synonymous with investing efficiency and has been widely adopted by the financial services industry.

Markowitz’s Thinking in Several Areas:

Artificial intelligence

Artificial intelligence — quote-unquote — is artificial idiocy. It’s a program! It follows somebody’s rules. Programs are based on theories. And programs may contain a bug. If bugs in airplane artificial intelligence could cause the airplane to crash, could a bug in robo-advisor artificial intelligence cause a portfolio to crash? Robo-advisors bring information and advice to its users. And that advice can be either good or bad. If the advice is good, good for you.

Diversification and Modern Portfolio Theory

The main idea behind diversification is to minimize risk for a given return. We’ve all heard that putting all your eggs in one basket is not a smart thing to do. And there’s a trade-off between risk and return. If you don’t face risk, you typically don’t have opportunity for return. The world is a risky place as long as you want to earn money and invest money. (But how do you quantify risk? - My comment.)

“Do you think a U.S. recession will hit soon?”

“Yes, of course.  But the question is: When?”

Now, this is Interesting from the father of Modern Portfolio Theory

“Some people believe there’s no need to diversify. Your Thoughts?”

“They come to sorrow.”

And yet

“When the [2017] hurricanes hit Houston and Florida, I sold my bonds except for some tax-exempt or tax-deferred ones. I [figured] all that damage had to be rebuilt. I went all-equity. It was the “Markowitz Bet.” I [deduced] that the building industry had to rebuild Texas, Florida and then Puerto Rico [after Hurricane Maria].”

“What stocks did you buy?”

“I went into three asset classes: big-cap, small-cap and emerging markets. In big-cap, I bought six
individual stocks [including] Caterpillar; 3M; and elevator companies, like Otis. I [also] bought [building products maker] U.S. Gypsum.”

“Did you win your bet?”

“The equities had a big spike and then came down, but I remained long. I got out of almost all my bonds, even tax-deferred or nontaxable ones because they were paying little. And I’ve been waiting.”

“For what?”

“When long-term tax-exempt bonds get to 4%, I’m going to rebalance. I’m just letting it ride and
ignoring the bond market until interest rates come up to a level that interests me.”

“How much longer can this bull carry on?”

“The bull market has lasted an awfully long time. It’s got to come down — someday. Markets go up; markets come down. There’s a natural cycle: People are enthusiastic, and the market goes up, up, up. The dumb money buys on the assumption that it’s going to go up further. Suddenly, people realize it’s overvalued, and it comes down faster than it went up. Then they decide it’s gone too low, and now it’s time to go up again.”

“What do investors do at that point?”

“Sell on the assumption that it’s going to go down further — whereas the smart money rebalances. All you have to do is rebalance. You can’t lose.”

Note how Markowicz describes above the emotional response people have to market volatility,
especially since the emphasis is on a growth orientation investment philosophy.

Key Takeaways
  • Artificial intelligence and robo-advisors are artificial idiocy – advice is based on a program
    following somebody’s rules and theories
  • Markowicz’s Modern Portfolio Theory is based on sufficient diversification to minimize risk for agiven return. ( I’m still not sure how you measure the risk or approximate the return). Yet
    Markowicz sold his bonds and went “all-equity” in 2017 when hurricanes hit Houston and
    Florida. Long-term tax-exempt bonds will need to reach 4% before he is getting back into the
    bond market.
  • And yet Markowicz has this suggestion for investors: “All you have to do is rebalance. You can’t lose.”
Key Takeaways

1 Where Harry Markowitz, Father of Modern Portfolio Theory, Is Invested Now - ThinkAdvisor
By Jane Wollman Rusoff | April 15, 2019

https://www.thinkadvisor.com/2019/04/15/harry-markowitz-talks-mpt-robos-and-where-hes-invested-now/?kw=Where+Harry+Markowitz%2C+Father+of+Modern+Portfolio+Theory%2C+Is+Invested+Now&fbclid=IwAR2GD1t5ejsdtN-z_WNPf-SsockNDkRhILH31C1caw5eRziYlGscusYXoZg