Investor Resources Inc

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MPT (standard asset allocation modeling) is largely dependent on normal distribution. Market returns are assumed to cluster in the center of the bell curve while the infrequent big changes dot the outer edges. Dr. Harry Markowitz received a Nobel Prize in Economics for his 1950's ground breaking work creating Modern Portfolio Theory.
If this method of analysis is valid we should be able to accurately forecast how often markets make large moves. Assuming this is valid allows financial advisors using MPT to adjust the risk in your portfolio.
Let’s take a look at how it has worked.

"From 1916 to 2003 there should have been 58 days when the Dow Jones Index Average moved more than 3.4%. Instead it happened on 1,001 days.

On October 19, 1987 (“the worst day of trading in over 100 years”) the Dow fell 29%. The odds: 1 in 10 to the 50th power – a number outside the scale of nature." *

Modern Portfolio Theory (MPT) does not provide sufficient downside protection for most investors to reach their goals, and, according to Dr. Markowitz, MPT was never intended to provide that protection. He recently explained that his theory never assumed distributions would be "normal," contrary to most financial text books, continuing education and mutual funds sales materials.

For investors and advisors who want to control downside risk, Dr. Markowitz recommends they create their own estimates of future returns and focus investing on lower returns. "...the 2008 market crash could happen again, he says. But you don’t know when. The losing cards are in the deck."

Dr. Markowitz’s financial situation does not represent the average American family when he says “I feel comfortable and have enough money in municipal bonds so that if I die my wife has enough to live off tax-free income. I can afford to be more in equities.” Ignoring the impact of downside risk is not a luxury most can afford.
CHANGE OR HOPE?
The annual study of the investing public conducted by Dalbar® provides significant insight to what should be learned from the 2008 market melt down. Study results are challenging the traditional use of Modern Portfolio Theory. "Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process."
Can we learn from history? Stocks for the Long Run has supported the “Buy & Hold” investing mantra ever since its publication. In a rising bull market, “buying on the dips” quickly erased losses from being a little too early in the dip. If examining the Japanese stock market instead of ours, the outcome would be different.

Why should you care? The state of our government's finances and the solutions for a slowing economy are too similar to ignore. Japanese investors have been experiencing a bear market since the 1989 peak. Buying and holding on - hoping – has led to a 72% decline as of early May, 2010. It was the world’s largest stock market twenty years ago. Not to be ignored, it is still the world’s second largest economy right behind the USA.

In Japan's 20 year bear market, there have been five major advances lasting roughly six months to more than four years. Index returns during those advances ranged from 34% to 135% for investors who adapted to changing economics and markets. “Buy and Hold” investors continue giving up their gains – a high cost for holding on.

Clearly, the markets are significantly riskier than MPT has led investors to believe. If only one of these items were accurate it would cast great doubt on the usefulness of MPT.
All of the events listed above did happen! Following MPT allocations means that you are just waiting for another “once in a lifetime market move” to blow up your portfolio again. We have watched this happen all to often with market volatility.
Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Improbable, has said: “Asset-class diversification remains desirable but is not sufficient.”
Portfolio construction and safety are directly linked to what the market is doing not what it is supposed to be doing.

By tracking the irrefutable law of supply and demand, market prices signal when and where to best deploy your assets. By listening to what the markets are doing, you are able to follow trends as they develop. Trends can be positive or negative. Paying attention and making portfolio adjustments is the difference between winning and losing.

“…the key to good performance is the ability to identify those stocks that are detracting from the performance of the portfolio. Most portfolio managers spend most of their time and effort trying to find the next big winner in the stock market but good portfolio performance depends more on finding and eliminating the bad stocks from the portfolio.”

Invest in markets or sectors with positive trends. Avoid or sell markets or sectors with negative trends. This process creates the possibility of preserving capital in declining markets while participating in rising markets or sectors.

Research by Dr. Ken French (of Fama & French fame) confirms that market strength is persistent. If one is willing to weed out weakness from a portfolio and rotate into relatively stronger performing stocks, portfolio performance improves significantly above the long-term average normally derived from Ibbotson data. Momentum, or Relative Strength, is a mathematical calculation allowing an investor to segregate portfolio holdings into tiers. Once identified, it is easier to make an objective decision to eliminate positions that are a drag on the portfolio.

Since 2008, academics and advisory firms have increasingly examined the underpinnings of the "Efficient Market Hypothesis" which asserts efficient distribution of information to the investing public. Therefore, public information, such as price, cannot provide an advantage in obtaining excess returns. Increasingly popular sector exchange traded funds (ETFs) combined with relative strength (momentum) rotation do seem to provide an advantage.

"In summary, simple sector ETF momentum strategies have generally outperformed the broad stock market over the past decade for reasonably low trading frictions...Including ETFs representing other asset classes (such as bonds, commodities, equity styles and international stocks) may enhance results."

As Dr. French (above) has written, the success of momentum strategies is hard to explain away. It has been an area of interest in the academic and finance communities for more than twenty years.

At the very least, relative strength systems can provide natural stops for equity traders and additionally inform them as to which classes, sectors, styles and countries are running hot or cold in the current market environment. At their best, they can make for powerful trading systems in their own right.

Dorsey Wright & Associates published additional research in 2010 using radom sampling of ETFs combined with Monte Carlos processes with similar conclusions. Using a universe of global ETFs, more asset classes and relative strength can provide enhanced portfolio results over a market cycle.

Investor expectations for high returns in the aftermath of the tech and real estate bubbles imploding have been dashed against the rocky shore of a transitioning global economy. Several decades of bull market appreciation led to assumptions about our future. The future arrived but the assumptions were overly optimistic. The "buy and hold" strategy has created investor disappointment if not significant losses.

Secular bear markets tend to endure almost as long as bull markets but require a different approach to grow and preserve capital.

We are in a new millenium. It is an increasingly global economy. We are transitioning to a "new normal." It is now time to Buy-DON'T Hold.

We, too, have found that additional risk management is achieved by including a cash proxy as an asset class, such as short-term Treasuries, in the relative strength analysis. The benefit of this process is illustrated in the history section of every 401k plan we have back tested. You can see the results by selecting a plan and clicking on the History Link on any of the plans listed.

* A Non-Technical Introduction To Benoit Mandelbrot’s Multi-Fractal View of Financial Markets Verses Modern Financial Models by Clifford J. Short lll, AAMS AWMA CPM