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Revisiting Modern Portfolio Theory (Diversification)

| May 04, 2021
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For those investors not familiar with modern portfolio theory, it is a concept introduced in the early 1950s that brought to light the notion of proper portfolio diversification for a given rate of desired equity market participation. It is a theory rooted in long-term outcomes and it remains a highly referenced process within the world of portfolio management today. The reason we are talking about modern portfolio theory (MPT) in this week’s commentary is because the ideas surrounding MPT can help investors reassess their equity market participation views for the future and allow them to shift their thought process away from a single metric and to a more objective metric. We believe this bares ultimate significance over the next three-to-five years. Let me explain.

For MPT to provide a basis of understanding, it is first critically important for investors to gauge what it is that they would like to achieve with their investment strategy. For example, if one investor is solely interested in outpacing a single index, whereas another investor would like to maintain a healthy long-term success outcome within their financial plan, then the underlying investment strategies for those investors will be drastically different. And rightfully so. The idea of modern portfolio theory provides a simple framework for a diversified portfolio that is not intended to solely follow any one single index, nor is it designed to produce an expected outcome that will definitively materialize in its entirety. This is often a misunderstanding for those investors that follow the premise of modern portfolio theory because such investors have not fully answered the question of what it is that they would like their investment strategy to achieve. If an investor seeks to outpace a single index (i.e., single metric focus) then MPT provides almost no context because its implementation does not conform to such a goal, despite conventional wisdom that MPT can be used in all possible investment scenarios. On the other hand, concepts of modern portfolio theory can be largely utilized within the construct of a financial plan because the metric of success becomes more objective over the long-term.

If all of this sounds complicated in any way, I want to shift focus on the ultimate question that encompasses modern portfolio theory – how will you, or how do you, choose your level of equity market participation? Will it be based on your financial plan or will it be based on your subjective willingness to accept a certain level of short-term volatility? The reality with MPT over the past ten years has been one of weak returns for those investors with lower equity market participation and notably higher returns for those investors willing to accept 80%, or higher, global equity market participation. Return profiles have also been impacted by the concentrated nature of U.S. equity markets, a notion that we have discussed extensively over the past few years. Does this mean that modern portfolio theory has not worked? Not quite. Our data leads us to believe that the effectiveness of MPT over the past ten years (i.e., diversification) has been highly dependent on the level of global equity market participation more so than ever before in its existence. This has been fueled by stock market dislocations alongside sector valuations that have defied the notion of risk management and exuberance. As a result, we may be witnessing the early inflection point of a dismantled modern portfolio theory.

So, why do we believe this bares ultimate significance over the next three-to-five years? For starters, we fundamentally believe that the next secular economic growth cycle remains in its infancy. Such cycles never loudly advertise themselves prior to their commencement and their validity can be downplayed by forces such as fiscal and monetary policy. The reality of that, however, is that politics and the Federal Reserve will likely do little to curtail consumer consumption, corporate innovation, and economic productivity over the next five years. Personal and corporate tax rate fluctuations have never historically resulted in a meaningful long-term economic slump, nor does the data reveal weaker consumer consumption patterns. We fully understand that such statements go against conventional wisdom, but they do remain historically accurate. If such a secular cycle does fully commence, then the spillover impact to global equity markets remains poised for upside in a healthy and justified approach. This should be taken in the context of a three-to-five-year snapshot.

With that in mind, modern portfolio theory concepts, and overall diversification, are likely to continue to post weaker long-term returns for those investors with lower equity market participation than those with higher household exposure to global equity markets. The benefit under lower equity market exposure stems from perceived protection against volatility, but I would urge caution in such thinking. Investors are often fascinated with bear markets for the wrong reasons. The reality of bear markets is that they have rarely impacted returns for investors with at least a ten-year time horizon. In fact, since the mid-1930s, the S&P 500 has posted a positive return in 93% of rolling ten-year periods. What this means [to us] is that the extent of diversification away from equity market exposure should be carefully assessed by investors as a means of achieving their long-term goals. This is important because at the end of the day, modern portfolio theory is just that – a theory.


Edison Byzyka, CFA – Chief Investment Officer – Credent Wealth Management

4/30/2021 Commentary

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Investment advice offered through CX Institutional, a registered investment advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.

All other data, including returns, soured from Bloomberg, through the release of monthly figures from the Department of Labor, Bureau of Economic/Labor Statistics, U.S. Census Bureau, or from the Federal Reserve and any of its affiliated regional locations. 

Small Business Optimism sourced through NFIB.  Small business hiring plans sourced through NFIB. Consumer sentiment sourced through the University of Michigan. 

Earnings data sourced through Bloomberg Intelligence and through Bloomberg’ earnings analysis composites.  Interest rate cut/rise probabilities are sourced from Bloomberg’s tracking of futures contracts tied to the Federal Funds interest rate.

Economic Policy Uncertainty data sourced from Bloomberg via The Baker, Bloom, and Davis Index.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changed in the aggregate market value of 500 stocks representing all major industries.

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