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Posts Tagged ‘MPT’

What could possibly link the children’s story of Watership Down, Thanksgiving turkey and retirement investing risks?

Well, my mind works in strange ways (just ask my wife and I’m sure my 15-month old Spencer agrees as well).

Buy and Hold – A Broken Promise?

After all the troubles in the stock market and in financial markets in general over the past couple of years, I was recently rereading an article in the trade magazine, Journal of Financial Planning. In the September 2009 issue there is a book excerpt by Ken Solow, CFP (R) entitled Buy and Hold is Dead (AGAIN): The Trouble with Quant Models.

Over the past couple of years there has been much written about Buy and Hold investing. You may be familiar with the concept as an approach to investing that focuses on selecting an investment (stocks, bonds, mutual funds, real estate) and simply holding on through good times and bad.  Occasionally, you should rebalance back toward some strategic assert allocation to reduce or minimize certain risks.

The reasoning behind this is simple: humans are bad at financial decisions and by adopting this approach you can take the emotion out of investing.  Too often, we tend to make important decisions with little information and rely on emotions like fear or greed.  In fact, Warren Buffet, investor-extraordinaire of Berkshire-Hathaway fame, has said this many times and by doing the opposite of what the masses do he has amassed a fortune for himself and his investors.

For many, buy and hold was discredited after the great Financial Meltdown that tipped us into the Great Recession.  All asset  classes – whether large company stocks, small company stocks, stocks of foreign firms, bonds from companies large or small and bonds issued by sovereign nations – went down.

Most investors feel cheated, angry and worse. This buy and hold approach was advertised as a way to minimize risk.  Unfortunately, most investors probably misinterpreted the idea of minimizing risk and thought that it eliminated the downside volatility.

As I often say to clients, we know there will be sunny days and rainy days.  Risk management means carrying an umbrella and maybe wearing a rain coat as well.  But just because you are using one or both of them doesn’t mean that you won’t get wet.  You’ll just not get soaked like the guy who’s running from the street curb toward the office door with nothing but a newspaper over his head.

It’s true that Buy and Hold will help take the emotion out of investing. Over the long-term, the Ibbotson Charts will show that all asset classes have gone up since 1926 until now even after the meltdown.

That provides cold comfort to the retiree who is just about to start withdrawals from his portfolio to supplement his retirement income and lifestyle.  There were many who saw their investments drop 30%, 40% or more.  And while their portfolio may have bounced back some with the market rally and over time the market may continue to rise, they just don’t have the time to wait.  They have to start taking out money now.  And each time they take out money to live on, there is less in the pot to grow.

This has happened before.  Remember Enron.  Remember Lucent Technologies.  On one day someone is a paper millionaire.  Fast forward and the companies are in the tank (bankrupt in the case of Enron) and your retirement dream is a nightmare. If you’re at the tail end of a 25 year career, you really don’t have the time to make it up but have to make do with what you have. (Even for these folks, not all is lost and there are things one can do to sustain a retirement as I noted here in a previous post. And I’ll be talking about sustainable withdrawal rates in another post on retirement income planning.)

For the rest of us, there is a lesson in there. And this is where Watership Down and Thanksgiving turkey come into play.

Buy and Hold, Modern Portfolio Theory & The Illusion of Math

Buy and Hold is based on the quantitative model of Modern Portfolio Theory (MPT) first devised Harry Markowitz more than 50 years ago.  Such quantitative models are based on lots of mathematics.  The formulas are complex and elegant.  They are beyond what most of us are comfortable with but they do provide a sense of security.  You input numbers from data on various asset classes and a very precise number comes out the other side of the black box.  This provides a sense of security.  Instead of relying on something subjective like your instinct or your gut feelings, you can put your faith into something objective like the science of math and finance.

Over the past few years and principally from the mid-1990s until our recent meltdown, we have come to rely on ever more complex quantitative models. These complex models drove the markets in real estate and mortgages as we relied more and more on the black boxes of the financial engineers.  But theories are only theories and models are only as good as the assumptions and data used to create them.

A chain is only as strong as its weakest link.  And a model is only as good as the assumptions behind it.  All models are based on past events. And even though we are warned that “past performance is no guarantee of future results” we rely on these backward-looking, statistically-based models for predicting our futures.

In a normal world, the behavior of markets and investors can be assumed pretty well. But in panics, all bets are off.  No amount of modeling can predict how presumably reasonable people will act but it’s safe to say that human nature’s fight or flight syndrome kicks in hard.

Watership Down – A Lesson from Spencer’s Bedtime

What happens is that things go along and work until they don’t.  Assumptions are assumed to be fine until they need to be revised. When I was reading Watership Down there is a scene where the protagonist, a wild rabbit, encounters a number of other well-fed white rabbits.  Our hero tries to get them to follow him but to no avail.  The tame rabbits live in a fine world where they are provided plenty of food, water, shelter and care.  What more is there to go searching for “out there?”

The Thanksgiving Turkey

Our false sense of security and belief in a system like MPT or Buy and Hold can be illustrated in the tale of the Thanksgiving turkey.

As retold by Nassim Taleb in The Black Swan:

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey:  It will incur a revision of belief.

Unable or unwilling to question its beliefs, the turkey was lulled into a false sense of security by his daily reinforcing experiences. Like the tame white rabbits in Watership Down, the turkey’s world is looking good and life is great.  So much so that neither even think about ways to escape.

At least in the animated movie Chicken Run with Mel Gibson (another soon-to-be Spencer favorite), the chickens are led to question their assumptions about life on the farm and plot ways to escape.

What We Learn from Bedtime Stories for Investing

What we learn from these stories is that just because things have worked in the past, doesn’t mean that they are absolute truths that will hold in the future. The most dangerous thing that an investor can do is simply accept with blind faith the assumptions of the past.  In a changing market, there’s nothing scarier than conventional thinking.

Theories are only theories and while it may seem like heresy to question assumptions, it’s in your best interest to do so.

Does this mean abandoning Modern Portfolio Theory or Buy and Hold? No.

It does mean that it makes sense to add some human judgment to the mix.  Good models can work even better with common sense.

Like the counter-culture of the 1960s would teach, you as an investor will do best to question authority and question assumptions.

Use an Investment Policy Statement as a Better Road Map

Here with the aid of a qualified professional you can walk through and create a personalized investment policy statement as a road map for investing decisions.

Such an approach can combine the quantitative tools to be used along with the more qualitative, value-based criteria that can be combined to help in the investment selection and portfolio management process.

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