Modern Portfolio Theory revisited

Yesterday morning I attended the St. Louis Chapter of the Financial Planning Association meeting to hear a presentation titled “Modern Portfolio Theory 2.0.”  It was excellent, no surprise, because it was presented by Michael Kitces  MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL whom I often describe as a “walking brain” when discussing him with peers.  He is also the author of a reference book I own, and to which I often refer.

Michael came in from the Washington DC area to share his research on market and economic history, the accompanying signals and data, and what it has told us about subsequent market performance.  He also had ideas for how this information could be layered on top of Modern Portfolio Theory in a tactical way to mitigate some risk in client portfolios.

Modern Portfolio Theory

In the 1950’s, Dr. Harry Markowitz pioneered the idea of considering your investment portfolio as a whole unit, rather than as individual securities, when measuring risk and expected return.   He determined mathematically, that you could put investments in the portfolio that had a bit more risk (more volatility) and yet create less volatility in the portfolio as a whole.

This reduction in volatility was accomplished by having investments that were not completely correlated, meaning they did not move in tandem.  So when one investment zigs another one zags.  In effect, when you have multiple investments moving in different amounts of up and down directions at different times, it creates a smoother path overall.

There are different steps involved in implementing Modern Portfolio Theory.  I gave a “plain English” version of the Asset Allocation step in my blog post “Peter Cottontail Makes A Lousy Investment Advisor!” which explains the reasons for diversification and rebalancing a portfolio.

Modern Portfolio 2.0

In his presentation Michael pointed out three factors that make following Modern Portfolio Theory, without any adjustment, challenging.

  1. Returns – they seem to vary for an extended period of time
  2. Standard Deviation – there are distinct high and low volatility periods
  3. Correlations – became close to 1 during the recent crisis

He shared with us different valuation data points, macroeconomic information, and technical trend analysis information to evaluate when considering adjustments to Modern Portfolio Theory inputs.

I have seen Michael speak on similar topics and can see that his research is expanding, he shared more data points and ideas for implementation than in the past.  I look forward to seeing where the research leads.

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