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.


James Kwak: the mutual fund company that oversees your 401(k) plan is out to get you

Economist James Kwak is now a law professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. In this piece James examines the conflict of interest between the asset management industry and the suffering 401K investor. Excerpt: 

(…) But wait, there’s more! In addition to these very real problems, 401(k) plans are generally run by the asset management industry, which (surprise!) does not always have your interests at heart.

Most defined contribution plans allow participants to select from a menu of investment options, largely mutual funds. The question is, who decides what’s on the menu? About three-quarters of the time, these decisions are made by a mutual fund company acting as the plan’s trustee.** And (surprise again!) mutual fund companies are more likely to push their own funds onto employees than other companies’ funds—despite the fact that they are legally obligated to act in the best interests of plan participants.

Although many people have suspected this all along, we now have convincing evidence from a paper by Veronika Pool, Clemens Sialm, and Irina Stefanescu aptly titled “It Pays To Set the Menu” (which was sent to me by two different readers). The paper uses a clever empirical approach. In any given year, a mutual fund may be included in 401(k) plans overseen by that fund’s sponsoring company (e.g., the Fidelity Magellan Fund may be included in a plan whose trustee is Fidelity) and also in other plans not overseen by that company. It turns out that there are many such funds.

Let’s say such a fund has a bad year. If plan trustees are acting solely in the interests of their participants, we would expect the identity of the trustee not to affect the chances that the fund is dropped from the investment menu. But that’s not the case: a poorly-performing fund is much less likely to be dropped from a menu controlled by its sponsoring fund company than from a menu controlled by a third party. Fund companies are also much more likely to add their poorly performing funds to plan menus that they control.

Much more.

David Swensen's Guide to Sleeping Soundly

Subtitle: Financial wisdom for troubled times—plus strong opinions on the current crisis—from Yale’s in-house Warren Buffett

Marc Gunther interviewed David Swensen for the Yale Alumni Magazine. Swensen took over management of the Yale endowment in 1988, growing the fund from $1 to $22.9 billion as of June 30, 2008, an annual return of 16%. Yale was down almost 25% in 2009.

Swensen is the author of Pioneering Portfolio Management, and Unconventional Success: A Fundamental Approach to Personal Investment. The first book is for managers with the mega-resources available to Swensen. The second book is targeted at individual investors.

I am sampling the Yale Financial Markets course run by Bob Shiller (available free at Academic Earth, and for those who want the audio-only format you can subscribe free at iTunes U). I highly recommend Lecture 9 Investing for the Long Run,  a guest lecture by Swensen. However fascinating, the lecture content is largely based on how Swensen runs the Yale endowment, and is thus unsuitable for individual investors smaller than Warren Buffett. In this 2009 post-crash interview Swensen concentrates more on the real world challenges facing those of us responsible for our own retirement funds. Here’s an excerpt from the interview sidebar summarizing his recommended asset allocation discussed in Unconventional Success:

30% Domestic stock funds

20% Real estate investment trusts

15% U.S. Treasury bonds

15% U.S. Treasury inflation-protected securities

15% Foreign developed-market stock funds (the EU, Japan, Australia, etc.)

5% Emerging-market stock funds (Brazil, Russia, India, China, Taiwan, Korea, and the rest of the developing world)

Today, Swensen says, economic conditions might call for a modest revision. He now recommends that investors have 15 percent of their assets in real estate investment trusts, and raise their investment in emerging-market stock funds to 10 percent.

Another example of the Swensen perspective on the individual investor:

Y: Maybe we need new language, David. No one wants to be in the “passive” group.

S: No, they don’t. The basic problem is, it’s boring. The approach that I recommend is going to give you absolutely nothing to talk about at a cocktail party. You’re going to be in a corner by yourself, and no one will pay any attention to you. But you’ll end up with a better-funded retirement.

Y: So you can host the cocktail party.

S: Right.

Y: Unconventional Success delivered a scathing critique of the mutual-fund industry. You rightly pointed out that the vast majority of mutual funds charge high fees, trade too frequently, and under-perform the markets. How did the industry react?

S: I’ve heard stories of people in the fund management business being irate about the book. That’s not surprising. The mutual fund industry is not an investment management industry. It’s a marketing industry. And if somebody interferes with your marketing, you’re not going to like that. So I was pleased to hear that there were senior people in the industry who were very, very unhappy with me and my book.

Y: We should note that there’s a distinction between the for-profit mutual fund industry and companies like Vanguard and TIAA-CREF.

S: One of the fundamental points in Unconventional Success is that there’s an irreconcilable conflict in the mutual fund industry between the profit motive and fiduciary responsibility. There are two major organizations, Vanguard and TIAA-CREF, which operate on a not-for-profit basis. That conflict between profit and fiduciary duty disappears. Vanguard and TIAA-CREF are dedicated to serving their investors. They are shining beacons in this otherwise ugly morass. As a matter of disclosure, I’m on the board of TIAA.

But the sad fact is that this book, along with books written by Jack Bogle and Burt Malkiel and a handful of others, are relatively small voices when set against the cacophony of the fund management world. Look at Fidelity and Schwab with their full-page advertisements. Or Jim Cramer [host of CNBC’sMad Money]. The investor is bombarded with staggering amounts of information, staggering amounts of stimuli that are designed to get the investor to buy and sell and trade, to do exactly the wrong thing, to create excessive profits for these intermediaries that aren’t acting in the investor’s best interests.