None of us have enjoyed the last three years. And of course, after a traumatic event
people look for reasons and answers. It’s natural to question your assumptions. Actually,
we must constantly test our beliefs and investment philosophy to see if it’s still valid.
However, far too much of the recent commentary has been focused on the very near term
and was way off base. If you are going to publish investment advice and commentary, at
least get your facts straight. Otherwise, we are in danger of learning the wrong lessons
from our experiences.
Modern Portfolio Theory Failed
Modern Portfolio Theory simply advocates diversification with assets that have low correlations to one
another as a method of optimizing a portfolio to provide the maximum expected return
per unit of risk that the investor is willing to tolerate. No one has ever argued that it
eliminates risk, guarantees a profit, or prevents loss. A lower investment outcome relative
to the expected return during any particular period should happen about half the time,
and we can get a general feel for the range of possible outcomes that a portfolio might
experience. MPT says nothing about the timing of events which are presumed to be
random and unpredictable.
No matter how far you diversify an equity portfolio, market risk remains. That’s the risk
that cannot be diversified away. Investors expect higher returns over time in exchange
for holding risky assets, and in a properly diversified portfolio those returns are generally
related to the level of risk that they assume. But the single most important decision an
investor must resolve is the diversification between risky assets (stocks) and low- to zero-
risk fixed income (short-term, high-quality bonds, T-Bills, certificates of deposit, money
markets, and so on). There diversification worked perfectly.
Correlations Moved to One
So what? Correlations are not fixed over time. They increase and decrease in a random
fashion. During a financial panic all equity assets may very well move together as
frightened investors seek safe haven. That’s happened time and time again and is to
be expected. But, as the crisis abates, asset class performance again diverges, and the
benefits of investing in asset classes that have had historically low correlation again
Efficient Market Theory Failed
Because asset prices moved rapidly and widely, a number of commentators complained
that markets couldn’t be “right” when prices were high, and “right” when prices plunged.
They simply misunderstand. No one held that prices were “right” in any absolute sense.
There is no conflict between markets being efficient and irrational, exuberant, or volatile.
Paul Samuelson held that while market prices fluctuated randomly they were probably
the best estimate of intrinsic value. You can’t do better by looking at a firm’s accounting
data or other measures.
Gene Fama’s Efficient Market Theory holds that prices quickly adjust to new information
that arrives randomly, and that trying to outguess market prices by technical analysis,
fundamental analysis or market timing is unlikely to add value over and above the cost
of trying. The price isn’t necessarily “right” but it’s fiendishly difficult to outguess a few
billion of your closest friends who are looking at the same data in real time.
Buy and Hold Failed
Buy and hold doesn’t guarantee a successful investment. And there are plenty of
times when your portfolio is totally wrong. After all, holding on to your 100 shares
of Enron is a losing strategy. And it doesn’t mean that you won’t have ups and downs
in your portfolio. That’s part of the investment process. Holding an inappropriate
portfolio is always inappropriate. If you have concentrated stock positions, an otherwise
inappropriate asset allocation, or have invested at the wrong level of risk, it’s time to
rethink and optimize your portfolio to your long-term needs.
But, buying a diversified portfolio matched to your unique situation, holding it through
thick and thin with occasional rebalancing to maintain the integrity of the asset-allocation
plan still offers the best hope of long-term success.
We Have to Be More Tactical
After a decline in prices, you might expect market timers to emerge singing their shop-
worn siren song, and they rarely miss the chance. A few folks invariably made the right
call, and we can expect to hear about it for the rest of our lives. One call does not a genius
make. However, if you are delusional you might begin to believe that your one lucky call
was really skill.
Unfortunately, the folks that are calling for a more tactical approach to the markets can’t
tell us how to do it. Are we supposed to just wake up with a gut feeling? If no one has
ever been able to do it consistently before, why should they be able to do it now? What
fundamental research supports this harebrained approach?
It’s seductive. All of us would have just loved to have avoided the down market.
But there isn’t a shred of evidence that anyone can successfully and consistently add
value to a portfolio by attempting to time the market. Any claim otherwise is simply
disingenuous, self-serving, voodoo finance.
Stocks Had a Lost Decade
Simply not true. The S&P 500 is not the market; it’s a part of the world’s market that
just happened to be one of the worst possible choices for the last decade. Lots of bonds
probably did better than the S&P 500, in fact anything positive did better. Many equity
asset classes did very well indeed, and a properly diversified portfolio did very well. See
my article, Worst Market Decade Ever–Not So!
What Has Changed?
Nothing changed! Markets go up and down. It’s a fact of life. An appropriate investment
strategy anticipates and accounts for market volatility. We know with certainty that bad
years are going to happen, even if we don’t and can’t know when. Throwing out every
time-tested, successful, long-term strategy and everything we have learned about how
markets work would be the height of folly. If your asset allocation is appropriate for your
financial situation, and is properly diversified, stay the course.