Markowitz and MPT Misunderstood

Modern Portfolio Theory (MPT), as developed my Harry Markowitz in the 1950’s, is supposed to be a theory of tradeoffs between investment risk and potential return. MPT has served as the supposed basis for many financial advisors to develop their investment portfolios and asset allocation models. However, MPT as intended by Markowitz, has aspects that have been widely overlooked, misused, misunderstood, and maybe even twisted by the financial services industry.
In his published research entitled “Portfolio Selection” in the Journal of Finance in 1952 he led with:
“The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio.”
Many “diversify and buy-and-hold” or strategic asset allocation users cite the work of Dr. Markowitz as the basis of their framework. But that may not have been what he intended. Yes, stocks have more risk and therefore generally expected higher returns than bonds over the long term, but what if your timeframe is not seventy-five to one hundred years? What if you are starting from a period of relatively high stock valuations and therefore an expectation of below-average stock returns?
In looking at all of the rolling ten year periods over the past 100 years it becomes quite obvious that it makes a HUGE difference in realized returns depending upon what the market valuations were at the starting point. “Conventional wisdom” has forgotten or ignored the essential “first stage” of portfolio management according to Markowitz. Too often, MPT is used with the assumption that future returns will be in-line with long term average returns without regard to the valuation of the market at the starting point. Though future performance of the stock market cannot be predicted with certainty, insights and observations and experience about the cycles that exist within the market and the importance of valuations can head us in a more correct direction with expectations of future returns and how to plan.
Currently, valuations by several measures that have a high degree of historical accuracy show the stock market as very highly valued and that the expectation over the next several years is more biased towards risk rather than return. This fact is being ignored by most advisors and portfolio managers however. They are still using long term average returns as their expectations and still building portfolios in what they have been lead to believe is in line with MPT. They diversify among asset classes and styles in the traditional 60/40 or other mixes and feel that all is well. They ignore the very important point of expected returns.
Ed Easterling at Crestmont Research is one of the top researchers in this area. Others, like John Hussman, Rob Arnott, and Jeremy Grantham of GMO are also thought leaders in this important area.
All of these people are in agreement right now that the expected average annualized return from stocks over the next ten years is somewhere between 2% to -2% and that the expected return over any time period of seven years or less is negative. That’s far from the regularly quoted, long term expected return from stocks of 10%.
So, in order for advisors to properly plan to get their clients where they want to be, it is extremely important to know where we are currently. This is exactly what Markowitz meant when he said:
“The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio.”
Now, using valuation measures alone for timing changes to the portfolio structure is not very effective. More recent academic research is finding that using approaches known as Adaptive Asset Allocation or Tactical Asset Allocation is very effective and uses systems that can tactically or adaptively adjust the portfolio allocation when needed using a repeatable, rules-based approach. Our AlphaRotation strategies use this type of tactical approach that can be very effective at implementing the theory Markowitz intended.