In short, MPT teaches us to minimize business risk by diversifying our stock holdings very broadly, and embrace market risk (volatility) as the most reasonable source of acceptable, even generous, returns. The ultimate diversification is an equity portfolio weighted in concert with the capitalization distribution of all publicly traded stocks so as to experience pure market returns with negligible "business risk." Where necessary, we can manage market volatility with appropriate doses of less-volatile, lower-return assets like short-or medium-term bonds.
Changed Circumstances?
Today, many independent advisors are finding that investing for clients with investment horizons of less than ten years is unusually challenging. They are skeptical of traditional long-term return assumptions because they share an uneasy consensus that both stocks and bonds are expensive. I say "uneasy" because to eschew a whole asset class because it seems expensive is to actually veer from MPT orthodoxy; it's like questioning your religion. If the market is really efficient, everything that can be known is already reflected in prices and there is no need to worry about valuation. Unless acclaimed author and practitioner Peter L. Bernstein is right ...
In the past year, Bernstein, an ever-cautious observer of the investment world, has made some radical-sounding statements. To paraphrase:
Long-run evidence (that stocks will provide superior returns) doesn't fit the circumstances as they are today.
Policy portfolios (i.e. fixed asset allocations that are regularly rebalanced) are obsolete. Managers will need to be more opportunistic.
More than a 50% stock allocation doesn't make sense (because the prospective equity risk premium is so small).
For now, equities are not the best place to be for the long run (ten years).
It sounds like Mr. Bernstein has concluded that it may now be worth the effort to measure stock valuations against current "circumstances," and to make investment judgments based on that appraisal. That is very different from MPT's working assumption that the market efficiently processes all information, and that one only need endure the short-term "noise" of cyclical corrections in order to achieve long-term returns superior to other asset classes.
I like Bernstein's choice of the word "circumstances." It is broad enough to include valuation concerns (is the P/E unrealistically high, even for a low-interest-rate environment?) as well as a wide range of economic variables that may impact future corporate profits and dividends.
We have enjoyed in these United States almost 60 years of peace and prosperity since the Second World War. Insofar as we humans tend to rely on recent experience in forming our expectations, it is not surprising that investors tend to anticipate a future similar to our past: 3.5% real GDP growth, 3% inflation, persistent productivity gains, stable currency, access to capital at a reasonable cost for both consumers and businesses, domestic tranquility and a smooth transfer of government power every four years. These "circumstances" are consistent with MPT's stocks-for-the-long-run philosophy.