Innovation is a staple in finance, but it's not obvious that new always leads to improved.
Wall Street's meltdown in 2008 and the Great Recession, for instance, were partly the unintended consequences of financial engineering. Can you really achieve better living through collateralized debt obligations and value-at-risk models? That's a tough sell in 2010.
Some Wall Street inventions are useful, of course, such as interest-rate swaps and ETFs. But the focus these days is on what's negative. "The concept of financial innovation, it seems, has fallen on hard times," Federal Reserve Chairman Ben Bernanke opined last year.
Good thing, too, according to several outspoken pessimists in the scientific community. Nobel Prize-winning economist Joseph Stiglitz fingered financial innovation as a contributing factor in the 2008 financial crisis. Meanwhile, a recent working paper by economists Nicola Gennaioli, Andrei Shleifer and Robert Vishny presents a formal model of how clever thinking on Wall Street threatens Main Street. According to the report, "Financial Innovation and Financial Fragility," financial engineering tends to promote instability because investors underestimate the risks of newfangled products.
Are the perennial efforts to update and reinvent portfolio theory any different? Is money management getting better? Have we really learned anything since the dawn of modern portfolio theory nearly 60 years ago?
On one level, it's easy to answer "yes."
The field of financial economics has made great strides in deciphering the mysteries of asset pricing. But while we know much more than we used to, it's not obvious that investment returns are superior, either in absolute or risk-adjusted terms. This is finance, not medicine or aviation. Measurable signs of progress arrive slowly, if at all.
To find out if the investing profession is moving forward, we start with the numbers-if there's any evidence of improvement, the proof should be in the portfolio return and risk profiles. But how to proceed? Investing strategies run the gamut in the 21st century. It's no easier to reduce the world of investing to a single measure than it is to summarize the Library of Congress in one book. A proper accounting of money management's output is complicated if not impossible. But the numbers are a good place to start.
So too is the financial advice guided by the classic interpretation of modern portfolio theory, which is the epitome of simplicity: Buy the market portfolio and customize the strategy by holding a degree of cash that's appropriate for a given investor's risk tolerance, investment horizon and so on. According to the old finance, everyone holds the market portfolio. The only distinguishing factor is the cash allocation.
How has the advice worked out? Much depends on how we define "the market." The time period matters, too. In other words, subjectivity lurks in the details. Yet we can develop useful perspectives by reviewing naïve asset allocation benchmarks as proxies for "the market."
A simple example is the long-term history of various blends of domestic stocks and Treasury bonds. Unsurprisingly, higher allocations to equities are linked with higher return, according to Ibbotson Associates. But they are also linked to higher risk (the annualized standard deviation of return). History suggests, too, that mechanical rebalancing juices the results a bit (see Figure 1).
Holding a basic portfolio of U.S. stocks and bonds over the long haul generated an annualized return of roughly 6% to 9.5%, depending on the exposure to stocks and the rebalancing rule. Over shorter periods, the results can and do vary quite a bit more. In the decade through 2009, says Ibbotson, a 50/50 unrebalanced mix of stocks and bonds delivered less than 4% a year-a sharp drop from the nearly 14% return for the previous decade. Adding a bit of cash (Treasury bills or the equivalent) lessens the volatility, though it also slightly hampers return.
Looking at portfolios in this way suggests that there are several basic strategies for enhancing return. One is buying and holding a different asset allocation, or managing asset allocation dynamically. Another possibility is picking individual securities within the asset classes. But the task is tougher than a simple analysis would suggest.
Defining "The Market"
A proper reading of modern portfolio theory requires looking beyond a portfolio of U.S. stocks and Treasury bonds. In theory, the market portfolio holds all assets, weighted by market value. The true market portfolio isn't practical, of course, but we can build a reasonable if less-than-ideal proxy.