Modern Portfolio Theory (MPT) had its day in the sun. Sharpe was a professor of mine in business school. He is a very intelligent man. His theory appeals to the hunger in all of us for an understandable, almost mechanical way in which to invest money. For those that do not know much about it, key aspects are "alpha" and "beta". Close your eyes if you are math-phobic, but it involves the equation of a straight line…y=mx + b as we were taught in school. "m" and "b" are not very sexy, so it was changed to "b" for beta and "a" for alpha. The beta represented the slope of the line…think seesaw…and the alpha was where the line crossed the y-axis. If I remember correctly, you plotted the returns of a stock for the past 200 trading sessions versus the S&P 500…put those points on a scatter diagram with an x- and y-axis, and then mathematically drew a line that best mirrored the pattern of the dots. Beta is the slope of the line, alpha was the crossing point on the y-axis. A steep line/high beta meant that when the S&P moved a little, the stock moved a lot both up and down. When the S&P 500 showed a zero return and the stock under investigation still showed a positive return, that was the "alpha"…what you got when the market in general did nothing.
The line was called the "characteristic line" for the stock under investigation. Since each stock has this "systematic risk" – S&P doing one thing, the stock doing the other in concert – the idea was that you could pick a slope that matched your ability to handle risk. Steep slope = not for everyone, gentle slope = probably for most.
One problem was that each company represented by the stock market had "specific risk"…e.g. bankruptcy, product line problems, competition, etc. Sharpe et al determined that a portfolio of 17-20 stocks with a characteristic line with a specific beta gave the expectation that you could chose your slope and your alpha, but the specific risk would be minimized given that there were multiple stocks involved.
That was the theory. Graduating in 1973 and thinking I had been given the secret weapon with which to invest, we tried to apply it. General Motors had a very low beta (slope) based upon the prior 200 trading days. However, the '73-'74 bear market was caused by a drastic increase in gasoline costs. A manufacturer of gas guzzlers was not a good place to be. GM dropped like a stone. I discovered that it is the future beta that matters not the prior beta. If I only had the future 200 trading days to compute the beta, I would be in great shape. Alas, I realized that if I could foretell the future, I did not need Bill's theory…
.
Another aspect of the mechanical investing crowd was to build a portfolio of non-correlated assets. Think of pistons in an engine. The pistons go up and down, but the car keeps moving forward. That approach works if you are in a generally positive investment environment as we were from the early '80s until the early 2000s. Unfortunately, the correlations are not static. They change. This was apparent for all to see in the 2008 meltdown. Virtually everything converged on a correlation of 1. It probably would have been total had it not been for trillions of dollars spewed out to save the banking system and sovereign governments (think bonds).
The last mechanical approach that I will mention is this idea of "small cap", "mid-cap", "large-cap", and "domestic vs. foreign" investing. First of all, I never understood why the capitalization was a factor unless the company was truly huge or tiny. The law of large numbers was the consideration for the former and liquidity, the latter. As I would hear people talk about this over the last ten years, I finally started accusing people…with a wink…:-)… of investing in adjectives. They would describe their style and allocations using these adjectives, but could not tell you what they really owned. That is a very careless and hazardous way to invest. It is promoted by the all-powerful consultants, so it is hard for people to stray from the mindset, though.
A major reasons that mechanical investing schemes fail is that economics do work in the long run. If someone does have a unique approach, it attracts a huge following as well as vast sums. As the advantage becomes well known, the excess profits shrink and ultimately disappear. There was alpha when T. Rowe Price and John Templeton were in the heyday of their careers. Templeton was investing in such areas as Japan and South American decades before the rest of us. The disappearance of alpha and the correlation of assets has to do with global markets, the Internet and the massive increase in the size of the investment pool created by the increase in population and the massive amount of fiat currency that has been created. There are exceptions, but alpha in the past decades involved leveraged-beta for most.
What I was trying to convey about allocation being so important is that it is still just as true as it always was, but it should be based on common sense themes and where Chris Martenson's followers believe we are heading…and I am one of them. You don't need alpha and beta, you don't need Monte Carlo simulation. You don't need mindless allocation sold to you by the wire houses. Use your head and common sense. Peter Lynch of Magellan fame was the master of this. He went to the mall. He saw what people were buying. He would look for major trends in the population and the economy. If he liked the sector, he would just buy all of the good companies in that sector. There was little consideration to indexing and looking like his peers.
The pendulum has swung back to the so-called little guy and the patient analyst. The institutions have too much money to invest in anything other than a small universe. The HFT crowd are really just battling each other at the nanosecond level for an ever-decreasing piece of the action.
Institutions also operate by a creed: look like the others. When it comes to gold, silver and the miners, they will be loathe to take positions until they have no choice. There is no personal upside for being an oultlier if you are wrong. They will stay with their peers in group think until the crowd moves. That will come, but at much, much higher prices. For many, keeping their job and their cash flow is what matters, not absolute performance. For those who have expressed frustration about being ignored by their brokers and advisers, if you are with a large firm, recognize that your concerns will not be addressed until it is common knowledge. That is why you should be applying common sense, history and open thought to how you approach your money.