I think we will soon see a period of great volatility in the markets.
One solution for dealing with market complexity and uncertainty is to diversify trading strategies. This requires a rethinking of Modern Portfolio Theory (MPT).
Modern Portfolio Theory must change
For successful investing in the future, I think MPT must change. MPT is all about cutting down portfolio volatility. It says that one should diversify among noncorrelated asset classes. That plan is great when asset classes are truly noncorrelated. But 2009 showed that they no longer are.
I think it will be better to have different trading strategies that are not held to a buy-and-hold process for any particular asset classes. Call it MPT 2.0.
Harry Markowitz’s seminal paper on Modern Portfolio Theory was published in 1952. But his work didn’t achieve importance until the early 1970s, when stocks and bonds got slammed at the same time. This changed investors’ ideas of risk and return. It gave new life to his theories.
One important aspect of Markowitz’s work is the concept of utility and preference. It showed investors how to trade off risk and return on an “efficient frontier.” This is the act of knowing one’s portfolio risk profile and deciding what level of risk is appropriate. Where do I want to be on the efficient frontier?
Complexity is not always better
Many investment advisors use Markowitz’s concept of the efficient frontier and asset class diversification. But they make their client’s portfolio much more complex than it needs to be. That can give the client a false sense of security. And it makes people accept volatility.
But the efficient frontier is always moving. You can’t plan your investment portfolio today and expect the best results for years to come. Especially when your decisions are based on history that is not going to repeat.
I did not at first understand MPT. I thought that MPT is about diversifying among noncorrelated asset classes. And it is. But I had a false notion about the importance of certain asset classes.
I had looked at the correlation of the asset classes that were “going to one” in times of crisis. I thought that using MPT would only diversify one’s losses, not smooth out one’s returns.
The key to MPT is in the words diversification and noncorrelation. The asset classes are just tools.
I think that many share my false notion. We assume we are limited to the most easily traded asset classes (stocks, bonds, real estate, etc.).
A deeper understanding of asset classes is more important than history
I now know that diversifying trading strategies is just another use of MPT. Hence, MPT 2.0. I can still use all the asset classes mentioned above. But I don’t have to use all of them at the same time.
There used to be many asset classes that did not correlate. International stocks and US stocks showed very different correlations and trends. Not so much anymore.
Markowitz’s answer would be to change the asset classes in your toolbox. To continue to look for assets that do not move in the same way as others.
Most “correlation studies” use past data to predict future correlation. That’s pretty much all we have to determine correlation. But I’ve come to see that one must know the core structure of the asset strategies and classes involved.
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