In 1952, The Journal of Finance published an article by 24-year-old Harry Markowitz that discussed a method for balancing risk and return in the construction of diversified portfolios. For years, financial advisors used Markowitz's modern portfolio theory to build diversified portfolios for their clients. They were pretty happy with the results. Then came 2008.
To say that diversified portfolios didn't perform well during the market meltdown of 2008 is an understatement. Most asset classes declined significantly in value during this period, dragging diversified portfolios right along with them. As a result, many advisors pronounced the death of the theory and called for its unceremonious burial.
But word of the theory's death is premature. No one enjoyed the experience of 2008, but Markowitz's theory was not to blame for our suffering. He never suggested that it would save us from a widespread market decline. Those that relied on it to do so did not understand it.
Modern portfolio theory is a tool, not an answer. It offers a recipe for building diversified portfolios based on assumptions about what will happen in the future. But it does not tell us very much about how to develop those assumptions, and it certainly does not guarantee that the portfolios we build will be immune to market declines. In fact, Markowitz tells us we cannot diversify away all risk.
Like most tools, it is only helpful if used properly. Unfortunately, it is often implemented in ways that blunt its usefulness, ways that were not prescribed or encouraged by Markowitz. These methods simply emerged as practitioners struggled to address issues that he did not address in his paper.
So let's take a look at how the tool works and, more important, let's explore some ways that it might be implemented to get better results. No matter how it is used, the theory cannot immunize our portfolios from declines in value. But by improving the way it is used, we can improve the likelihood that our clients will reach their long-term goals.
In the Doors song "Roadhouse Blues," Jim Morrison sings, "The future's uncertain and the end is always near." This idea underlies modern portfolio theory. Markowitz assumes we will build diversified portfolios because there is no reliable way-at least in the short term-to predict the performance of each asset class. He suggests that even if we could, we would still prefer a diversified portfolio because we couldn't stand the volatility associated with investing in a single asset class.
Next, Markowitz assumes that when we build diversified portfolios we will already know what assets we are going to use. He offers no guidance for what those ought to be other than to say that you can use either individual securities or what he calls "aggregates"-what we would call asset classes. He leaves open the question of what should go into the mix.
Many advisors today do not use a sufficient number of asset classes in their portfolios. This is understandable. Becoming familiar with new asset classes requires research, and new products emerge every day. Sorting them out requires effort, but that effort is worthwhile.
For example, the collapse in 2008 was widespread, but it was not universal. There were a few bright spots. Managed futures had strong positive returns. They would not have saved a well-diversified portfolio from losses that year, but they would have cushioned the blow.