It seems that not a day passes without my seeing an article claiming modern portfolio theory is dead. That also seems to go for terms used synonymously with MPT: "asset allocation," "strategic allocation" and "buy and hold" investing.
What surprises me is that today's MPT critics seem to believe they have just discovered the truth, when in reality a new group of gurus consistently discover the same truth after every bear market.

If anyone deserves credit for thoughtful and legitimate criticism of MPT when misapplied, it is William Jahnke. Although we disagree on many issues and I've debated with Bill over many years, his February 1997 article in the Journal of Financial Planning, "The Asset Allocation Hoax," remains the most notable piece on the subject. Long before today's critics appeared, Bill was writing articles about it for the Journal, including his February 1999 piece, "Portfolio Management: Why Setting an Asset Allocation Policy Is a Bad Idea," and his June 2004 article, "It's Time to Dump Static Asset Allocation." In these papers, he lays out several criticisms of MPT:

The allocations are solely and simplistically based on projected historical data. "In essence," he writes, "we forecast that the long-term average historical correlation is an accurate estimate of the future correlation between investments."
Contemporary market valuations are ignored. Traditional methodology assumes valuation is irrelevant.
Allocations are determined at the beginning of the investment process and are never changed, except when they are rebalanced. "The idea that the most important investment decision should be fixed at some arbitrary point in time is strange advice."

A more recent criticism of MPT is Kenneth Solow's recently published Buy and Hold is Dead (Again). In this excellent book, Solow echoes and expands on the criticisms raised by Jahnke.

Although I agree that many practitioners who follow the tenets of MPT develop allocation models based simply on historical data, the criticism should be leveled at the practitioner, not the process. I can only assume that the critics have failed to read Harry Markowitz's seminal paper, "Portfolio Selection," from the Journal of Finance, 1952.

Markowitz writes this about portfolio selection: "The first stage starts with observations and experience and ends with beliefs about the future performances of available securities." (Emphasis mine.)

In detailing what he refers to as the "expected return-variance of return" (the "E-V rule") he writes, "To use the E-V rule in the selection of securities, we must have procedures for finding reasonable µi [the expected return] and sij [the covariance]."  The reader should pay close attention to the terms "future performances," "reasonable" and "expected," as I believe many critics missed these caveats.

Lest a reader not get the point, Markowitz continues, "These procedures, I believe, should combine statistical techniques and the judgment of practical men. My feeling is that the statistical computations should be used to arrive at a tentative set of µi and sij. Judgment should then be used ... on the basis of factors or nuances not taken into account by the formal computations." (Again, emphasis mine.)

He is quite clear in rejecting the approach of using historical projections. "One suggestion as to tentative µi, sij is to use observed µi, sij for some period of the past," he writes. "I believe that better methods, which take into account more information, can be found."

Financial planners who dipped into my own book Wealth Management over a decade ago would have also read my warning: "Since the optimization process [for asset allocation] is purely quantitative, we then apply a qualitative overlay based on investment judgment to arrive at our recommended allocations. Extrapolation of historical returns assumes that return series are stable. Unfortunately, they are not stable. ... Research to date suggests that simple historical projections do not seem to offer an acceptable solution for return projection. I do not believe that a wealth manager should use them as a basis for optimization input."

Another criticism of asset allocation is that it ignores contemporary market valuations, a complaint integrally related to the historical data issue. Although admittedly there is no guarantee of accuracy, if a practitioner does not use historical projections but rather develops his or her own input for the optimization process using forward-looking expectations, the assumptions will factor in market valuations. In fact, even after the practitioner incorporates valuation-based, forward-looking expectations in the analytical process, he will still need to then use judgment that takes into account other factors, as Markowitz suggests.

The third criticism of MPT is that allocations are determined at the beginning of the investment process and never changed, except when they are rebalanced. Again, this criticism should be leveled at those practitioners setting their policies in stone. There is nothing in the literature or in practice to suggest that a policy allocation should not be revisited and revised when and if forward-looking market expectations change. I can't speak for other planners; however, it is our practice to review our assumptions at least annually, and our "strategic" allocations do in fact vary over time as a result of changes in our world view.

The bottom line is that practitioners may develop allocation models based solely on projections of historical data, but MPT does not. Practitioners may also ignore valuations; MPT does not. And practitioners may design allocation models and set them in stone; again, MPT does not.

The Alternatives
I only know of three alternatives to MPT-market timing, absolute return and tactical allocation.

As for market timing, I can make this argument short and sweet. Name the ten most successful market timers of all time. How about the top five? The top one? I agree that if an advisor could consistently predict which markets would be up and which down, he would have to be pretty foolish to diversify. Why on earth would I invest in stocks if I knew the market was headed down? Had I posed my challenge back in the '80s, many would have pointed to Joe Granville.

What, you haven't heard of Joe Granville? Until the late '80s, he was the market guru. Like many gurus, he had absolute confidence in his crystal ball. According to Robert Shiller in the book Irrational Exuberance, Granville was quoted by Time magazine as saying, "I don't think that I will ever make a serious mistake in the stock market for the rest of my life," and he predicted that he would win the Nobel economics prize. In 1981, when he was grossing $6 million a year for his newsletter advice, his two-word "sell everything" warning to his subscribers triggered a massive market sell-off with a record number of shares trading around the globe.

Just before the 1987 crash, he again warned of a market disaster. He was obviously correct on that call and his picture was on the cover of major magazines and papers around the world.

Maybe you haven't heard of him because his crystal ball, like others, had flaws. A few years ago, the Hulbert Financial Digest reported that The Granville Market Letter "is at the bottom of the rankings for performance over the past 25 years-having produced average losses of more than 20% per year on an annualized basis."

Until someone can name at least a few successful long-time market timers, I remain a skeptic and will continue to "bet" on some form of diversification.

Another alternative to modern portfolio theory is absolute return. If an advisor can manage to develop an entire portfolio of investments that provide an absolute return high enough to accomplish the investor's long-term goals, he might reasonably forgo worrying about MPT, allocation and diversification. For those who cannot locate the appropriate investments for such a portfolio, incorporating absolute return strategies into a strategic or tactical model may allow them to have the best of both worlds.

But here are words of caution from recent history: Beware a strategy pitched as "absolute return" during mild markets that turn into relative return investments during bear markets (e.g., hedge funds that defend their poor recent performance by comparing the results to the S&P versus an absolute return benchmark).

As for tactical allocation, here I'm a bit more conflicted, as I do believe in the fundamental premise-namely, that markets and investment classes and styles move in cycles and that markets tend to over- and underreact over those cycles, eventually regressing back to "normal" relationships. The problem is determining and accurately timing those moves.

For someone who believes in the basic tenets of modern portfolio theory, the good news is that MPT and tactical allocation are not mutually exclusive. There are a number of ways they can live in harmony. For practitioners confident in their ability to consistently manage tactical movements, a solution may be to establish a strategic policy with tactical bands. The width of those bands is directly proportional to the advisor's confidence in his tactical decisions (i.e., the more confident he is, the wider the bands). For those unprepared to regularly "bet" the whole portfolio on their tactical view, fundamental changes in longer market views can be reflected in revisions to the strategic model. The advisor can make shorter term tactical bets by implementing a core-and-satellite strategy-in other words, a strategic core and a tactical satellite.

Beating Overconfidence
Even as professionals, we are at risk of overestimating our ability to predict the future (in fact, perhaps more so) because as humans we have a tendency to overestimate our competence, knowledge and experience and our ability to control outcomes. We tend to overestimate the information we have (which creates a knowledge illusion) and the accuracy of our estimates and our abilities (which create control and experience illusions).

I know how tempting it is to look for "the answer" to miserable markets, particularly as we suffer from the lost decade. But it is dangerous to ignore the behavioral risk of overconfidence as you compete against the thousand other Tiger Woodses in the global investment markets.

In 1938, John Durand wrote Timing: When to Buy and Sell in Today's Markets, one of the early classics in active investment management. He also wrote How To Secure Continuous Security Profits in Modern Markets, in which he opined: "As this is written, one of the greatest bull markets in history is in progress. People have been saying for several years that prices and brokers' loans are too high; yet they go on increasing. ... People who deplore the high at which gilt-edged common stocks are now selling apparently fail to grasp the fundamental distinction between investments yielding a fixed income and investments in the equities of growing companies. Nothing short of an industrial depression ... can prevent common stock equities in well-managed and favorable circumstanced companies from increasing in value, and hence in market price." This advice was penned September 1928.

In March 1998, Brad Barber and Terrance Odean, two respected behavioral finance academics, published a paper often referred to as "the cost of a good idea." Based on the trading records of 66,465 households with accounts from 1991 to 1996, the researchers compared the performance of the stocks investors sold to the performance of the stocks they bought with the proceeds of the sale. They found that those who traded most (i.e., those investors with the most "good ideas") earned an annual return of 11.4%, while the market returned 17.9%. The average household earned an annual return of 16.4%. Their conclusion? "Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth."

If you remember the "New Era," you probably remember the money manager Robert Markman. In March 1999 he wrote, "The asset allocation zealots are mindlessly over-diversifying based on past performance. Ironically, it is the asset allocation zealots, in their rush to mindlessly diversify, who are projecting dangerously from past performance." In April he wrote "Bubble? What bubble? An all-time high often means the market is going higher. A lot of people talk about this all-time high as if it's a market top. ... This market high is a reflection of a strong economy. ... This market is different from the market top of the '60s. This market is different from the market of the early '70s. This market is certainly different from Japan. A lot of people are pulling out the old Japanese bubble stuff, saying it'll happen here.

Let's keep in mind in the late '80s, when the Japanese market was truly a bubble, the ground of the Imperial Palace in Tokyo had a greater market value than all the real estate in the state of California. That's a bubble! This is the future-changing right in front of us. What we have are some pretty high P/Es that are based on expectations of future growth. Those who can't understand this market don't understand the role of technology in our economy and how it's changing right before our eyes."

I know you've all seen the charts: "If you missed the x best days," your return would have only been x%. That obviously begs the question: Why would someone miss those few best days? The answer is, the market moves up just as quickly as it moves down. According to one recent study, 70% of the best days in the market occurred within two weeks of a worst day (14 out of 20 days) and 100% of the best days occurred within six months of a worst day (20 out of 20 days).

Consider, more recently, Stephen Feinberg, co-founder of Cerberus Capital Management. Cerberus bought 51% of GMAC in 2006 for $14 billion, and 80% of Chrysler for $7.4 billion.

You can also think of Leon Black, the CEO of Apollo Management. Black's private-equity firm bought Linens 'n Things in 2006 for $1.3 billion with a plan to revive the ailing retailer and sell it for a profit. Instead, the company declared bankruptcy. In 2007, Apollo paid $6.6 billion for Realogy-the parent of Coldwell Banker and Century 21 real estate brokerages-just as the housing boom was inverting.

Finally, remember that in predicting the future the key is not simply getting a single prediction correct; it's getting all of the interacting consequences correct. Ask yourself, just two years ago, would you have confidently predicted that we would elect our first African-American president in 2008? Would you have imagined that Citigroup would trade for a time under $1 or that General Electric would trade for a time under $6 or that Bear Stearns and Lehman Brothers would virtually vanish? That Chrysler and GM would file bankruptcy or that a graduating class of law students would be unable to get jobs? Or that high-end MBAs would be unemployable?

And would you have guessed that we would have a fall of more than 50% in the broad stock indexes or that it would subsequently be up almost 30% in less than one month? Or that oil would triple in price and then fall by more than $100 a barrel? Some gurus might have seen parts of this pattern, but all of it? Again, life is far too complex to be predicted with any consistency.

Are you sure you'll be more successful than other gurus?

Before you decide to kill off MPT, consider that the real problem may well be that you are confusing the concept with the implementation, and beware of selecting alternative strategies that may be harmful to your clients' financial lives.