Paul Pfleiderer: Investing & Modern Portfolio Theory

Stanford prof. Paul Pfleiderer is an advisor to Wealthfront. In this article for TechCrunch he refutes some recent attacks on Modern Portfolio Theory (MPT). Recommended:

A few weeks ago, TechCrunch published a piece arguing software is better at investing than 99% of human investment advisors. That post, titled Thankfully, Software Is Eating The Personal Investing World , pointed out the advantages of engineering-driven software solutions versus emotionally driven human judgment. Perhaps not surprisingly, some commenters (including some financial advisors) seized the moment to call into question one of the foundations of software-based investing, Modern Portfolio Theory.

Given the doubts raised by a small but vocal chorus, it’s worth spending some time to ask if we need a new investing paradigm and if so, what it should be. Answering that question helps show why MPT still is the best investment methodology out there; it enables the automated, low-cost investment management offered by a new wave of Internet startups including Wealthfront (which I advise), Personal Capital , Future Advisor and SigFig .

The basic questions being raised about MPT run something like this:

  • Hasn’t recent experience – i.e., the financial crisis — shown that diversification doesn’t work?
  • Shouldn’t we primarily worry about “Black Swan” events and unforeseen risk?
  • Don’t these unknown unknowns mean we must develop a new approach to investing?

Let’s begin by briefly laying out the key insights of MPT.

(…) One of MPT’s key insights is that while investors need to be compensated to bear risk, not all risks are rewarded. The market does not reward risks that can be “diversified away” by holding a bundle of investments, instead of a single investment. By recognizing that not all risks are rewarded, MPT helped establish the idea that a diversified portfolio can help investors earn a higher return for the same amount of risk.

(…) Modern Portfolio Theory focuses on constructing portfolios that avoid exposing the investor to those kinds of unrewarded risks. The main lesson is that investors should choose portfolios that lie on the Efficient Frontier, the mathematically defined curve that describes the relationship between risk and reward. To be on the frontier, a portfolio must provide the highest expected return (largest reward) among all portfolios having the same level of risk. The Internet startups construct well-diversified portfolios designed to be efficient with the right combination of risk and return for their clients.

Now let’s ask if anything in the past five years casts doubt on these basic tenets of Modern Portfolio Theory. The answer is clearly, “No.” First and foremost, nothing has changed the fact that there are many unrewarded risks, and that investors should avoid these risks. The major risks of Zynga stock remain diversifiable risks, and unless you’re willing to trade illegally on inside information about, say, upcoming changes to Facebook’s gaming policies, you should avoid holding a concentrated position in Zynga.

The efficient frontier is still the desirable place to be, and it makes no sense to follow a policy that puts you in a position well below that frontier.

(…)

I recommend the complete article. An excellent companion article is by the father of the Sharpe Ratio, Stanford prof. William Sharpe: How to Invest In a Turbulent Market. There are many useful insights. Bill closes with this:

The equities market is around an all-time high. Should future retirees buy in now or wait for it to get cheaper?

I wish I knew whether in a year, we will look back and say that the current level of the market was an all-time high. But I don’t, and would warrant that few, if any, do. Better to assume the equities market is somewhat more likely to go up than down and act accordingly.