Financial wisdom hasn’t been nullified by the latest crises
1 THE GLOBAL FINANCIAL CRISIS WAS A BLACK SWAN
This is perhaps the biggest myth about the crisis. By definition, a black swan is an unprecedented major catastrophic event. However, there were many previous such crises whose long history motivated the late Hyman Minsky – writing in the mid 1980s – to formulate his “market instability” hypothesis to explain past crises and predict this one. Indeed, UK investors need only to recall the early 1970s to remember a time of even worse markets when equity investors lost 74 per cent over a two and a half year period and took over nine years to recover.
2 DIVERSIFICATION DID NOT WORK DURING THE CRASH
This myth is due to an exclusive focus on equities. While it’s true that equities lost value worldwide during the crash, the same is simply not true across the asset classes. In fact, during the crash, investors fled to safety and in so doing drove up the price of high quality sovereign bonds (especially US Treasuries) causing asset class diversification to work when it was needed most. So while US stocks lost 47 per cent of their value for the year 2008, a portfolio of 50 per cent US stocks, 40 per cent bonds, and 10 per cent cash would have lost a mere 16 per cent of its value.
3 MODERN PORTFOLIO THEORY IS DEAD
The essence of modern portfolio theory (MPT) is that investors should hold diversified portfolios, such that reward cannot be increased without an increase in risk and visa versa. The limitations of MPT – as first formulated by Harry Markowitz in 1952 – lay not in its principles but in the maths that he used. The maths simply could not handle the sort of extreme events that occurred during the crisis. In confusing the maths with the principles, some have declared MPT dead. Nothing could be further from the truth. In 2012, we now have powerful enough mathematics and computers to apply the principles of MPT in light of the types of extreme outcomes that markets produce from time to time with the advantage of far more robust models.
4 ASSET ALLOCATION SHOULD BE USED TO BALANCE RISK
Noting that portfolios created according to the principles of MPT lead to portfolios in which equity exposure is the primary source of risk, some asset managers are today switching to a “risk parity” approach to asset allocation. In this approach, an asset mix is chosen to achieve a portfolio where all asset classes contribute equally to the overall risk; this, they point out, is not the same thing as allocating the portfolio equally among the asset classes. Since this leads to a low risk/low return portfolio, the entire portfolio is then highly levered to goose up the expected return. Why anyone thinks this is a good idea in a post-crash world is beyond me. What the risk parity approach is missing is the fact that the sources of risk are also the sources of return. Since equities remain the main source of long-term growth, it follows that equities should be the main source of risk.
5 FUNDAMENTALLY WEIGHTED INDICES ARE BETTER THAN MARKET-CAP WEIGHTED INDICES
Since equities are the main source of growth for long-term investors, it is no surprise that someone will claim to have found a better way to invest in them. One such claim is that if we weigh stocks by “fundamentals” such as earnings, dividends, revenues, etc, rather than by market capitalisation, we can create better index funds. However, it turns out that this approach is nothing more than placing a value tilt on a portfolio. Since value tilted portfolios over the long run tend to outperform the market, so do these fundamentally weighted index funds. The downside is that these products also do poorly when value investing in general does poorly.
Paul Kaplan is the quantitative research director of Morningstar Europe and author of Frontiers of Modern Asset Allocation, published by John Wiley & Sons.