Modern Portfolio Theory has come under significant scrutiny over the past decade as many of its assumptions have been proven to be, at best, only partially true. Despite
these questionable assumptions MPT can still provide a useful framework for investors.
By modifying a few of the assumptions in MPT and implementing it within the context of Behavioral Finance we can provide a framework for successful investing in a world where humans do not always behave rationally.
The most fundamental tenet of MPT remains its most useful component – investors have the greatest opportunity for success if they build portfolios of diversified components. The cliche, “Don’t put all of your eggs in one basket,” is as true today as when the phrase was first uttered.
Portfolios will exhibit reduced volatility when non-correlated investments are combined. The problem with the conventional implementation of MPT is that the assets typically utilized have become more correlated over time. The advantages of strategic and tactical asset allocation have been largely negated by the increased correlations and reduced returns of the standard assets used.
The “lost decade” for equities has been well documented. The returns for the broad market and most of the typical equities sectors have been flat since 2000.
More importantly, the correlations of the asset classes typically used for classical portfolio allocation have increased substantially as shown on the following table.
Most equity sectors are now correlated 85-95% or more with the S&P 500, significantly diminishing their value for diversification purposes. Even non-equity asset classes such as commodities, bonds, and REITs have seen their correlations increase.
Likewise, the following graphic demonstrates that correlations of country ETFs have increased substantially over the past decade and continue to trend upward.
So if conventional asset allocation is not the solution, what is? The Machine Advisor offers a new way to provide the advantages of portfolio diversification. The benefits of diversifying investments promised by MPT can still be achieved by utilizing strategy (i.e. model) diversification instead of, or in addition to, asset class diversification.
The Machine Advisor allows financial professionals to build portfolios from diversified strategies with lower and more stable correlations to the broad market. The table below compares the correlations of typical asset classes used for MPT portfolio development compared to the active investing strategies available with The Machine Advisor.
Many active investing strategies have half the correlation of the typical equity asset classes. Of these classes used in conventional asset allocation, only bonds and gold provide decent non-correlated diversification. The Machine Advisor allows for bonds and gold to be added to active investing strategies to provide a complete solution for MPT 2.0.