Chapter 1 – Problems with Modern Portfolio Theory

Summary: What is the value of diversification and how much diversification do you need?  What is risk?  This is part one of two parts for chapter one. Don’t let the big words keep you from reading the full post!

Do you want to avoid unwise risk? Then understand what is and isn’t really risk-creating. In this chapter James Cloonan reviews “modern portfolio theory” (MPT), the efficient market hypothesis, the random walk theory and risk aversion.  He says, “The underlying assumption of modern portfolio theory in any model based on return and risk reduction is that investors want to avoid risk.” (p.39) He also reminds the reader: “It is possible for a risky asset (when measured separately) to reduce the risk of the portfolio when it is added.” (p.40-41)

RISK – In MPT, risk is reduced using diversification.

  • Because each investment has its own UNIQUE risks, if you increase the number of assets, the unique risk is reduced. In other words, if all your investment dollars are the stock in a company you work for, you have accepted very high risk.
  • Another aspect of risk is SYSTEMATIC risk. That is the risk that ALL stocks will crash during a depression or the “Great Recession” we saw during 2008-2009.  Here is what I found most interesting in this section: “Research has shown that the effectiveness of diversification tapers off after the stock portfolio exceeds about 20 holdings.” (p.41-42) The reason I am intrigued by this is that I have 34 positions in my ROTH IRA and 165 in my primary traditional IRA.  There is some overlap between the two, but for all accounts (brokerage and IRA’s) the total unique positions are 224.  Am I too diversified? I have a sound reason for my approach: I like having a regular dividend stream from multiple stocks and ETF’s. I receive income every month. My risk from diversification is very low.

CORRELATION – The next section of this chapter talks about CORRELATION.  This is important to understand this concept. It has an impact on diversification and reducing volatility within the investment mix.  For example, some investments tend to move in opposite directions.  When investors are fearful of systemic market risk they tend to move to utilities and consumer staples – like groceries = everyone eats.  They understand consumers will continue to use electricity, gas and buy the necessities of life.  At the same time, other sectors can experience the flight of investment dollars.  Everyone is selling and there aren’t enough buyers.  Some years I “beat” the S&P 500 index and other years I don’t. I don’t care.

VOLATILITY – Volatility is not risk! In MPT, “volatility is used as the measure of risk.” (p.45) The author has a view very much like mine.  He says, “I do not use ‘volatility’ and ‘risk’ as if they were the same concept, as is done in most investment writing.  While they have some relationship, particularly in very short-term investing, volatility has little to do with risk for the long-term investor.” (pp.50-51) Let that sink in.  This is a VERY important conceptVolatility is “the likelihood of shifting quickly and unpredictably” but the relevant definition of risk has to do with the “chance of injury, damage or loss.”  The reality is you shouldn’t (or can’t) manage volatility. You cannot. Focus rather on risk!

APPLICATION – Think about this:

  1. How much diversification do I need? Perhaps just 4-5 good ETF’s with a low fee structure is best.  Perhaps just 20-25 good company stocks. For ETF’s consider DVY, VYM and ITOT.
  2. Risk: Can you change your mind-set to view volatility as something other than risk if you have a long-term perspective regarding your investments? How might this affect your emotions when others are fearful and jumping out of the market?