Modern Portfolio Theory is much riskier than you have been led to believe.
MPT (standard asset allocation modeling) is largely dependent on normal distribution. Market returns are assumed to cluster in the center of the bell curve while the infrequent big changes dot the outer edges.
If this method of analysis is valid we should be able to accurately forecast how often markets make large moves. Assuming this is valid allows financial advisors using MPT to adjust the risk in your portfolio.
Let’s take a look at how it has worked.
"From 1916 to 2003 there should have been 58 days when the Dow Jones Index Average moved more than 3.4%. Instead it happened on 1,001 days.
There should have been 6 days the Dow swung beyond 4.5%. There were 366.
In 1997 the Dow cratered 7.7% in one trading session. The odds: 1 in 50 billion.
In July of 2002 the Dow declined sharply three times within 7 trading days. The odds: 1 in 4 trillion.
On October 19, 1987 (“the worst day of trading in over 100 years”) the Dow fell 29%. The odds: 1 in 10 to the 50th power – a number outside the scale of nature." *
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Clearly, the markets are significantly riskier than MPT has led investors to believe. If only one of these items were accurate it would cast great doubt on the usefulness of MPT.
All of the events listed above did happen! Following MPT allocations means that you are just waiting for another “once in a lifetime market move” to blow up your portfolio again. We have watched this happen all to often with recent market volatility.
Portfolio construction and safety are directly linked to what the market is doing not what it is supposed to be doing.
By tracking the irrefutable law of supply and demand, market prices signal when and where to best deploy your assets. By listening to what the markets are doing, you are able to follow trends as they develop. Trends can be positive or negative. Paying attention and making portfolio adjustments is the difference between winning and losing.
Invest in markets or sectors with positive trends. Avoid or sell markets or sectors with negative trends. This process creates the possiblity of preserving capital in declining markets while participating in rising markets or sectors.
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