Diversify? Good Luck

Whenever the market goes through periodic convulsions, as it did in August and likely will again, you hear the concept of diversification praised. The most celebrated system for diversifying is called Modern Portfolio Theory. Don’t fall for it.

One of the criticisms that I often hear about MPT is that it doesn't work as well as it did in the 1990s, when the market was rising. That is not true. MPT works just as well as it did at any time in history, which is not at all.

The main idea behind MPT is that there is an optimum portfolio where the combination of non-correlated assets creates an overall mix that can have a better risk/reward profile than the individual asset classes on their own.  

From an academic standpoint, MPT is very interesting because the optimum portfolio mix does exist. The problem is that I can tell you what it was yesterday but I have no idea what it will be tomorrow, and that is where MPT becomes useless in real life.

To decide how much to allocate to each asset class, you need to predict:

1. The future returns of each asset class.
2. The future volatility of each asset class.
3. The future correlation of each asset class.

If you could accurately predict all three of those things, then MPT would work great. You would predict the crash in stocks in 2008 and the rise in bonds, along with the lack of correlation. An MPT portfolio would then have 100% bonds and investors would be protected. Unfortunately, you can't predict any of these variables, making MPT of no practical use.

So why did MPT appear to work in the 1990s? Because anything that told an investor to buy stocks worked. I could have had a monkey throwing darts at an asset allocation chart and I would have made money. That doesn't make it a valid strategy.

MPT depends on normal distributions of risk and return, charted statistically. But in the market’s 2008-09 meltdown, those normal distributions got thrown into disarray once Lehman Brothers collapsed. Then, corporate bonds, real estate and commodities followed stocks into the tank, and chaos ensued.

The lone major asset that didn’t slump was U.S. Treasuries – everyone crowed into them for their perceived safety. There was no way to find adequate diversification during that storm.

Trouble is, MPT rests on another theory, called the efficient market hypothesis, which holds that investors are rational and well-informed. But all too often, emotions and lack of information rule investor decisions. The 2008-09 panic illustrates that well.

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Matthew Tuttle, CFP, is chief executive of Tuttle Tactical Management in Stamford, Conn., and the author of How Harvard & Yale Beat the Market. He can be reached at 347-852-0548 or mtuttle@tuttletactical.com

Nothing in this article should be interpreted to state or imply that past results are an indication of future performance. Please consult your tax or investment advisor before making any investment decisions.

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