If you are an investor guided by a financial advisor or a solo investor who makes investment decisions on your own, you may know about Modern Portfolio Theory (MPT) put forward by Harry Markowitz, an American economist. 

In 1990, Markowitz was awarded the Nobel Memorial Prize in Economic Sciences for his Modern Portfolio Theory. The Nobel Prize winning theory defends a diversified, or an ‘optimal’ portfolio. That is, a portfolio that allocates assets to maximize return by taking up a quantifiable amount of risk. In other words, a quantitative risk assessment method could be implemented along with diversification and calculated asset allocation to bring down investment risk.

Nobel Prize Portfolio in a Nutshell 

Modern Portfolio Theory, proposed by Markowitz initially as a research paper to build a portfolio of assets to deliver maximum returns with a stipulated level of risk, was first published by the Journal of Finance in 1952. A portfolio built on Modern Portfolio Theory is also known as the Nobel Prize Portfolio.

Prior to Harry Markowitz’s Modern Portfolio Theory, the returns from investing were largely calculated in terms of the performance of an individual investment. Markowitz demonstrated that the collective performance of the assets in a portfolio is more significant in generating returns than the performance of a particular asset or stock. 

A portfolio with diversified investment classes and financial instruments has lower correlation to each other. That means, their performance and returns vary in accordance with different stock market cycles and macroeconomic conditions. This variety in investment classes and securities reduces the volatility of a portfolio and guards it against unexpected financial market shocks. 

The quantitative risk analysis method of a Nobel Prize Portfolio uses the past data on investment risk and returns along with the expected investment returns in future. It also takes into consideration the investor preferences to build an optimised portfolio of assets that delivers the higher returns at the lowest possible risk. 

Shortcomings of a Nobel Prize Portfolio

The major shortcoming of a Nobel Prize Portfolio is the complexity associated with its mathematical model. The quantitative risk analysis method of MPT is based on the evaluation of historical investment returns and volatility. That means, the portfolio can be highly vulnerable to unknown variables in the future or the ones investors fail to consider during the time of creating the equation. This risk analysis method based on projected values and predictive mathematical calculations is far from reality and fails to deal with the risks in the real investment world. In other words, the investing process may appear orderly using the mathematical risk assessment model of MPT; yet, in reality, it makes a probabilistic risk assessment, not a structural one.

In the late 1970s, a researcher named Sanjay Basu demonstrated something contrary to the Modern Portfolio Theory: low price-to-earnings ratio (P/E) stocks outperform high P/E stocks. In the early 1980s, Rolf Banz, another finance scholar, demonstrated that small capitalization (small cap) stocks outperformed large capitalization (large cap) stocks. His theory is popularly known as Small Firm Effect.

This is another reason – apart from abiding by the Securities and Exchange Bureau of India (SEBI) guidelines – most investment firms never fail to note ‘past performance does not necessarily predict future results’ in the documentation of their investment products.

There is a greater irony: The father of Nobel prize winning Modern Portfolio Theory never trusted his brainchild when building his portfolio. Jason Zweig, a well-known financial journalist, mentioned this in his bestselling book Your Money and Your Brains. Here is the excerpt from the book – an expert in linear programming, he [Harry Markowitz] knows that “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up, and I wasn’t in it — or if it went way down and I was completely in it. My intention was to minimize my future regret. So, I split my contributions 50/50 between bonds and equities”. 

Why did Harry Markowitz choose an equal weightage asset allocation in his portfolio? Why did he avoid his Nobel Prize winning investment theory?

The answer is quite simple: He chose simplicity over complexity. 

Simplicity Is the Key

According to Albert Einstein, “if you can’t explain it simply, you don’t understand it well enough.” 

Einstein is right both in scientific and investment terms. In the world of finance, simple investment theories and practices always have an upper hand over sophisticated strategies and theories. A simple investment strategy is the best strategy an investor can ever adopt.

Nevertheless, the human mind always hunts for complexity and sophistication as we believe that only through sophisticated investment strategies, we can beat the market. Investors, especially the ones with larger capital allocation, fall prey to his terrible investment mistake. 

Even market pundits are not saved from this trap. The market genius who talks nonstop about the future of the stock market or particular securities makes us believe that he or she knows everything about the financial markets and the investment world. But in reality, they are simple humans with sophisticated investment strategies. Most of them don’t know what they don’t know and their job demands giving out careless opinions and comments on both finance and non-finance matters.

Just take a few seconds to think, how many of these experts predicted the CoVID spread and subsequent financial market downturns all over the globe? How many of them successfully predicted the bullish market trends in the financial markets all over the world soon after the turmoil?  

The purpose of this article is not to question Harry Markowitz’s Nobel Prize Portfolio or to blame market pundits. Here, the objective is to shed some light on no matter the level of our expertise, we fail miserably to predict the unknown future. As investors, we may have solutions to known investment risks, but when unknown risks are concerned, we render clueless. Every investment theory, including MPT, may guard us against known risks but, unfortunately, not against unknown risks.

Bottom Line

Diversification and calculated capital allocation are the best hedges against unknown risks. A solid hedge against complexity is always simplicity. Never confuse yourself with the sophisticated investment strategies proposed by your financial planner or portfolio manager. Always remember that complexity damages your hard-earned capital. Simplify your investment strategies and invest only in the stocks of the businesses that are simple to understand. 

Justin Raj

Alpha Research Team