More than one year after the collapse of Lehman Brothers and the subsequent meltdown in the financial markets, many long-held investment tenets are now being questioned. The validity and utility of modern portfolio theory as the prescription for prudent portfolio management is being re-examined. Dealing with this issue and developing solutions to cope with the revelation of newly uncovered risk is imperative if we are to successfully guide our clients through this tumult. It is equally imperative for our own survival to meet this challenge directly and develop strategies to navigate the financial minefield.

With two major declines over the past eight years, the stock market is on pace to underperform every decade over the past century, including the 1930s. During this time, modern portfolio theory represented the investment methodology most widely employed by advisors. It mandated a strategy of allocating funds to a wide array of asset classes in an effort to lower risk. The Holy Grail was to identify lowly correlated or even negatively correlated assets that would allow a portfolio to withstand the most severe declines.

In fact, even during the tech meltdown in 2000, modern portfolio theory seemed to work as advertised. While growth stocks plummeted, performance for asset classes such as bonds and REITs flourished. Those portfolios that allocated sufficient funds to these assets were generally able to rebound within 12 to 18 months after March 2003, the unofficial end of the tech meltdown.

When Long-Term Capital Management collapsed more than a decade ago and placed the financial system on the brink of systemic failure, it was only a harbinger of the more widespread and dangerous situation we would experience in 2008. Instead of learning from the mistakes that led to that episode, firms such as Bear Stearns and Lehman Brothers actually escalated the danger by engaging in similar activities with derivatives. While the benefit of derivatives in risk management clearly had been demonstrated, the abuse of these vehicles and the lack of regulation over them created entanglements where the bottom-line financial exposure was simply incalculable. After years of sparse regulation, there was finally an explosion.

There had been early warning signs all along, but the majority of us failed to take heed. In addition to this derivative frenzy, three other developments-the securitization of formerly illiquid assets, the growth and significant impact of the futures market and a global economy awash with cash-resulted in higher rather than lower correlations among global markets. When the subprime mortgage market began to unravel in 2007, these forces combined to create a liquidity crisis not experienced since 1929.

All assets, including REITs, commodities, bonds and stocks experienced historic declines as investors rushed to cash. Even renowned investors such as David Swenson, the legendary portfolio manager of the Yale Endowment, experienced severe losses despite investing in esoteric and seemingly non-correlated assets such as timber. For those investors who remained loyal to the tenets of modern portfolio theory, there was no refuge and many portfolios lost as much as half their value.

While the recent 50% rebound in the S&P 500 has at least temporarily allayed some fears, many stock market historians suggest that this represents a short-term rally in a secular bear market where further declines are imminent. Investors continued to be wary as new money remained largely on the sidelines and only existing investors have participated in the rally. The great fear among many advisors is that if another precipitous decline occurs, many investors who stayed the course will capitulate this time and be unlikely to return to the market anytime in the near future, much as the Great Depression generation remained on the sidelines for decades.

Even before events began to unfold, some lone wolves in the forest warned us about the perils in the system. Professor Nouriel Roubini of NYU predicted the housing bust, oil shocks and declining consumer confidence that would result in a deep recession. He also warned that venerable Wall Street firms could collapse as a result of the severity of the crisis.
Another obscure economist, Hyman Minsky, dead for 13 years, prophesized a scenario of financial decimation eerily similar to what occurred. In fact, the term "Minsky Moment" has been coined to describe the types of conditions experienced last year.

While Roubini and Minsky warned all who would listen about their financial meltdown scenario, another voice offered an interesting and novel approach to dealing with catastrophic events. Nassim Nicholas Taleb, a former options trader and hedge fund manager, wrote the book The Black Swan where he dismissed the laws of probability as a guideline to investing and instead urged investors to focus their investment strategy on the unknown rather than the known. Taleb argues that despite the seemingly miniscule possibility of unexpected yet catastrophic events occurring, the ramifications of failing to account for these events can be disastrous. Examples of highly improbable yet calamitous events are Black Monday (1987), 9/11 and, of course, the 2008 meltdown. Taleb claims that almost all consequential events in history arise from the unexpected. He argues that a portfolio must not only protect itself from negative events but also be positioned to exploit positive ones.

Taleb contends that small bets on improbable events can produce enormous gains as multiples of the actual investment. A recent example is the estimated $2.5 billion that hedge fund manager John Paulson reportedly earned by betting against financial companies heavily involved in the subprime mortgage fiasco.

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