About 12 years ago, I began writing a weekly online investment column for MSN Money. My colleague, Jim Jubak, focused on market trends and specific stocks. I couldn't do that. I was afraid. I suggested my column be called "The Cautious Investor." I would write about safe, namby-pamby, diversified investments and asset allocation for novices.
I considered myself a value investor at the time. But I soon got smug. The correspondents on the MSN Web site continually advised others: "Dump your advisor. Dump asset allocation. Dump value. Growth is where the action is." I listened to the people I was supposed to be teaching, sold value funds like Oakmark Small Cap and the Dodge & Cox Stock Fund and bought growth stocks like Qualcomm and Cisco and TransSwitch. Within a year, my $39,200 portfolio grew to $235,000. I wrote a column called "The Unmaking of a Value Investor," for Bloomberg Wealth Manager. Plenty of money managers agreed with me. Remember Robert Markman? He published a book in early 2000 called Hazardous to Your Wealth: Extraordinary Popular Delusions and the Madness of Mutual Fund Experts. Markman claimed asset allocation was dead. The only fund category worth buying was large-cap growth, he said.
Had there been a structural change in the market? Was it the end of the Cold War?
I hadn't heard about black swans. But some people had: Those who had read the book The Black Swan by Nassim Nicholas Taleb. The book examines the influence of highly improbable and unpredictable events that have massive impact, an important and timely topic since we're now facing yet another crisis in people's faith about asset allocation.
Taleb told Joe Nocera, who wrote a story on risk for The New York Times Magazine, that as a trader he made money only three times in his life-in the crash of 1987, in the dot-com bust and now. Not only did he make money-he made a killing. His fund was up 65% to 115%.
But Taleb also told Nocera that people cannot imagine a future different from their own past experience. That's why most of them thought of the 20% drop in the Dow Jones Industrial Average in October 1987 as "a worst-case scenario." But the prize goes to those who can imagine a future worse than that.
Like Taleb, Horace "Woody" Brock, believes that using historical returns to predict the future is folly. Brock is the founder and president of Strategic Economic Decisions (a company that provides research and macroeconomic analysis for high-net-worth individuals and institutions) and he has five academic degrees-a B.A., an MBA and an M.S. from Harvard and an M.A. and Ph.D. from Princeton.
I talked with Brock about modern portfolio theory and the future. It's not that the theory is broken, Brock says. "That's like saying Galileo's theory is broken." In other words, a feather and a lead ball still fall at the same speed in a bell jar with no air, Galileo found. And Harry Markowitz's portfolio theory works the same way. "MPT gave us a theory that works with no wind," Brock says.
But in physics, in economics, in science, we have to go from an extremely simplistic explanation of a phenomenon under controlled circumstances in a laboratory to a more complicated one in the real world, often with many variables that are unknown. We start with Galileo, but then move through Isaac Newton's theory and then go on to Albert Einstein, who took it all away. Knowledge builds on past knowledge.
And so Markowitz's modern portfolio theory, the idea of creating a portfolio that balances risk and return and then locating the portfolio on the efficient frontier, is the best an advisor can do for a client. Markowitz told us how to optimally diversify based on your own risk tolerance, and that, Brock says, was a major accomplishment.