Modern Investment Thinking Part III: Blinded by the Math

A Plague O’ Both Your Houses

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected]

 

Modern Portfolio Theory — Visualize Edvard Munch’s “The Scream”

In his April 20, 2010 post in Jotwell: Trusts & Estates: “Time to Rethink Prudent Investor Laws?”, Jeffrey Cooper paraphrases a similarly titled article by Stewart E. Sterk. Sterk, in my opinion, supports my assessment that Modern Portfolio Theory and it’s super-computer creation “The Efficient Capital Market Hypothesis” were directly, without any reasonable doubt, guilty of causing the recent global financial crisis.

By removing all “prudence” from the Prudent Man Rules that had governed trusteed investments for centuries, hypothesis and theory replaced profits and interest guarantees — probabilities, standard deviations, and correlations replaced real numbers, facts, and standards of real value.

Trustees were expected and encouraged to focus on the growth of portfolio market values instead of on the income the portfolios were expected to guarantee to the trust beneficiaries. Under the UPIA (Uniform Prudent Investor Act), absolutely anything was a viable investment medium for Trust Accounts — the result is history, a falling house of cards built on theory without substance.

About eight years ago, I had the opportunity to analyze the endowment portfolio of a local college. I literally could not recognize anything that was inside this eight figure portfolio. No “stand alone” identifiable stocks, bonds, government securities, Guaranteed Income Contacts — nadda!

Payments to scholarship beneficiaries and other recipients were routinely paid from new donations — similar to Social Security, Bernie Madoff, and other Ponzi Schemes.

MPT doesn’t just ignore all fundamental analytics while playing Frankenstein with technical analysis, it also pays no attention to the reality of market, interest rate, and economic cycles. It goes beyond real numbers and rational thinking by creating new and refined numbers — supercharged to impress the intellectual elite while doing nothing to create dependable income streams for retirees.

Simply put (whoa, scientists have no interest in making this stuff simple — it just wouldn’t be sexy enough for awards and accolades by their peers in academia and the media that follow such things.) So, simply put, we take a computer full of past market price numbers for a security or group of securities and calculate forays of additional numbers.

Then we measure how these manufactured numbers relate to one another during different time frames. The next step is to measure the dispersion of these results as they relate to the average and latest iterations of the actual numbers. We then measure the probability of each possible result, assign a “standard deviation” risk measurement to each result, and correlate/compare the various risk assessments.

Add a cup of single malt, and a pinch of Old Bay, bring to a boil, shake a stick over it and shazaam —- we “know” the risk associated with everything investment!

Portfolios are constructed so that everything owned (none of which are individual securities) is negatively directionally correlated to nearly everything else, producing, eh, producing — well I haven’t quite figured that out.

Simple enough? Well it sure is sexy, and painless when administered passively with Modern Portfolio Non-Management. Isn’t “passive management” an oxymoron

Modern Portfolio Non-Management (MPNM) — Houston, We Have A Problem

Even the “dinosaurous preposterous” Buym’ ‘n Holdm’ passive strategy of the 1900’s had a better chance of success (with some minor disciplinary and managerial tinkering) than the MPNM cop-out of the new millennium.

Here we are asked to accept non-management as a solution to a problem that exists only in the minds of product creators and financial institutions weary of regulators and lawsuits. It’s appropriate because it’s cheap and inexorably controlled by the immortal teeter-totter principle — very scientific indeed.

The unquestioning professional acceptance of Modern Portfolio Management just cries out for conspiracy theory analysis. Investors (and not just small investors) can go from Great Granddad’s first contribution to a UGMA account to their retirement program without ever owning a common stock or any form of individual income security.

Clearly, we’ve moved way too far away from the classic principles of investing. But how can we criticize a government that shows no respect for a capitalistic system that has produced the highest standard of living on the planet, when we, as investors, shun the basic building blocks of capitalism ourselves

How can we continually reelect full-of-themselves (I’m being kind) politicians who can’t connect the dots between higher costs of doing business and higher consumer prices; lawmakers kill businesses but don’t share the blame for falling 401(k) values with Wall Street product pushers

What’s a country to do?

Modern investment thought clouds the distinction between the purpose of stocks and bonds as it cleverly tries to erase the critical difference between an investment and a speculation. It supports the calendar performance evaluation idiocy, and panders to both a misguided tax code and a regulatory environment that paints all smal business financial professionals as charlatans and thieves — while having big Wall Street players on the sdvisory board.

But the mortal wound to most investment programs is a heightened misunderstanding of both the purpose and the operation of Asset Allocation.