By Oscar Miller
One afternoon while reading in the University of Chicago library, American Economist Harry Markowitz began questioning the proposals of John Burr Williams in his book Theory of Investment Value . Dubious about some of its assumptions, Markowitz began devising the basic components of Modern Portfolio Theory (MPT), which he would later showcase in his 1952 paper Portfolio Selection. MPT would go on to become one of the salient features of theoretical finance, for which he along with Merton H. Miller and William F. Sharpe would later receive a Nobel prize in Economics. The theory became an established mechanism through which retail and institutional investors alike could construct diversified portfolios comprised of multiple asset classes, minimising risk for a given level of expected return . Though a sharp spike in COVID-induced volatility may have exposed an overdependence on MPT on the part of investors, many of whom have witnessed a marked contraction in portfolio performance during the pandemic as to warrant a theoretical reconsideration.
Markowitz’ model depends heavily on the assumption that stock prices accurately reflect intrinsic value, or in other words, that markets are efficient . Those of Benjamin Grahams’ school of value investing have long been dismissive of this assumption, with the premise of Graham and Dodd’s 1934 book Security Analysis that investors should seek securities the market has undervalued by way of irrationality. The pandemic seems to have only further cemented market inefficiencies as share prices remain temperamental. Cross-industry stock returns have shown high variance, with some industries and their respective firms thriving under artificially high levels of demand while others feel the wrath of government-imposed coronavirus restrictions. International Airlines Group, which has a number of brands in its portfolio, saw returns fall by 62% in 2020, one of the hardest hit companies in the travel industry. By contrast, Ocado Group saw returns rise by 78%, and has recently outlined plans to expand its capacity in anticipation of grocery deliveries becoming a post-COVID norm . An unprecedented degree of informational interconnectivity paired with rapid technological change means asset prices have never been so sensitive to exogenous and endogenous shocks, thereby widening the scope for pricing inaccuracies and creating ample opportunities for investors. The pandemic may well have accelerated the demise of the efficient market hypothesis, whereby asset returns become increasingly leptokurtic and empirical deviations more pronounced.
Asset prices are a function of the transactional behaviour of individuals, so to assume prices accurately reflect true value is to assume buyers and sellers themselves act rationally. Investors and behavioural economists alike are aware of the theoretical deficiencies associated with this assumption. In 2002, Daniel Kahneman won the Nobel prize in economics for his work on judgement and decision-making under uncertainty, which attacked many of the neoclassical ideas about rationality on which MPT is grounded . Though you don’t have to look far beyond the works of Kahneman or Tversky to find incidences of irrational investment behaviour. In February 2020 when the virus began gaining traction, investors flocked to videotelephony providers like Zoom as businesses, universities and schools began to migrate towards digital platforms. Despite their intuition, many investors mistook Zoom Technologies Inc, a small Chinese holding company, for Zoom Video – driving the formers’ share price up 1800% by accident and prompting the SEC to suspend trading . This is not the first time the Chinese firm attracted unexpected attention, with many investors making the same error in 2019 when Zoom Video went public. Many economists have attempted to revive neoclassical rationality models by providing modernised extensions that account for the intricacies of human nature. But human nature will always be characterised by systematic erroneous behaviour, and portfolio models that assume otherwise will surely remain in the dark.
Of course, rationality concerns and theoretical shortcomings don’t completely discount the applicatory capacity of MPT. Markowitz’ approach has fuelled the recent drive towards passive management, whereby investors seek returns by minimising the degree of transactional activity – most notably via investment in index funds that represent a diversified bundle of securities . While passive investment strategies are not immune to criticism, active equity managers, on the whole, have failed to exploit COVID-induced volatility. The latest S&P Indices Versus Active (SPIVA) Scorecard showed that a majority of active managers failed to beat their benchmark in 2020, with 57% of actively managed broad US equity funds lagging behind the S&P composite 1500. Large-cap US equity funds also struggled, with 60.3% failing to beat the S&P500. This trend lingers over a longer time horizon, with 75.3% of large cap managers lagging behind the S&P500 in the last 5 years , evidence that the downturn in performance of active investment funds predates the pandemic. Low cost and well-diversified index funds are symbolic of the ubiquity of MPT, whereby individual stock losses are not so material as to place large amounts of capital at risk. Perhaps these contemporary extensions of MPT are more indicative of Markowitz’ practical foresight than of a theoretical model destined for the scrapyard.
Those that claimed diversification was dead in 2008 may well have jumped the gun, much like those who proclaimed its downfall as the pandemic took hold last year. Diversification sceptics would be accurate in their claims that portfolios comprised of multiple asset classes were not protected from the turbulence of 2008, where much like 2020, major indices took equally major hits. During economic crises, asset class returns tend to be more highly correlated as macro factors drive corporate cash flows . Of course, these positive correlations undermine the practical strength of Markowitz’ model to a degree, made worse by its assumption that correlations don’t change over time. But it would be foolish to discount its applicability entirely. Those same critics would be unwise to recommend investors be undiversified, nor it is likely they would be undiversified themselves. Needless to say, diversification is an insufficient risk management tool when used in isolation; a fire extinguisher may do little to combat a forest blaze, but it may provide some utility in containing immediate damage. A similar logic can be applied when assessing the practicality of MPT. Constructing a diversified portfolio comprised of multiple assets classes does not provide complete indemnity against systemic risks born out of global hyperconnectivity, but the difference it makes is by no means intangible.
The COVID-19 pandemic, much like the crisis of 2008 before it has certainly exposed some of the theoretical failings of Markowitz’ model. But equally, these crises have shown that while imperfect, MPT is robust and until we can formulate a new benchmark investment model, it may remain the strongest at our disposal.