Deciding what asset allocation to recommend is a challenging
undertaking. The majority of my peers rely completely on modern
portfolio theory (MPT), the credibility factor is high with this
approach. I am certainly not going to disagree with MPT. Never-the-less,
I decided a couple of years ago that it was time to step back and
review the tool and my results with MPT. The outcome was to realize
that the buck stops with me. Not someone's
excellent theory or someone's excellent software. Just me, right or
wrong. My training on the other hand is to employ a tool, based on MPT
theory, that has the credibility my name does not. After all, the brand matters in a world that values form over substance.
My experience after using MPT, for
nearly twenty years, is that the current markets are not the same
markets that the theory is designed to work in. MPT uses a fundamental
belief that there will always be a unique result from the use of various
styles of investment security. For example, owning securities from most
of the identified styles, like small cap blend and large cap value,
will create a diversified portfolio that minimizes volatility and
maximizes risk adjusted return. The unique result MPT user's expect is
different results between styles, or correlation, to each other. What is
occurring in today's experience is that the uniqueness is less apparent
and the correlation is too often similar rather than different. As
further contribution to this point, a Financial Times article titled "Decoding
the Psychology of Trading" adds much deeper insight than I have of
the changes occurring to the markets. Think about the 1999 movie, The
Matrix. It's feels like the system controlling the population is gradually happening.
Today we have access to
alternative investments. For example, the market is loaded with
securities that employ leverage which changes the character of the
market. There are now securities that use derivatives and they are tools
of change. The speed and sophistication of computer trading systems compounds these influences and the number of day traders seems to me, IMHO, to further modify the character of the market from what MPT is designed for. These are widespread innovations that MPT does not
recognize. As a result, I have been working for many months to develop a
macro economic understanding which will assist me in extending what I
know about MPT and develop an allocation recommendation that I have a
high level of confidence in. Periodically, I am reviewing my understanding and making appropriate changes. My current review is titled Economic Condition Review Q2 2010.