As a result of Wall Street propaganda and doublespeak, the investing public is at a huge disadvantage when navigating the markets. From sea to shining sea, broker dealers tout the mantra and sing the praises of Modern Portfolio Theory (MPT), also known as the Buy & Hold strategy. The name is misleading; MPT is anything but modern and was developed in the 1950s. The main ideas of MPT are that buy-and-hold strategies are best, and that there is safety through diversification. That sounds logical, but Buy & Hold often doesn’t work out as planned. Furthermore, outside of bonds, there is an extremely high degree of correlation across equity asset classes—making diversification an illusion.
Let’s take a closer look at what MPT really is: a passive investment approach. In no other life endeavors is passivity successful: not in raising children, career advancement, athletics, or any other field. Why should a passive approach work in the most highly competitive endeavor in the world?
The most dangerous part of buying into a passive strategy like MPT is the frequency of recent market disasters. It is only now that the market is back barely at or above 2007 levels after falling off to 6500 in February of 2008. Also, remember the fun in 2000, 2001 and 2002? Do you remember the Asian Contagion and The Russian Flu in the summer of ’98? What about the recession of ‘94? The recovery rate from recent market disasters has been abysmal. As of December of 2011, a buy-and-hold investor in the S&P 500 would still not be able to break even. The graph below shows the Value Added Monthly Index, tracking the value of $1,000 invested in the S&P 500 in January of 2007. While it is not possible to invest directly in the S&P 500, one can invest in a mutual fund that tracks the S&P 500. This would then include fees, possible commissions, and 12b-1s, creating a drag on the performance and likely making it so the mutual fund underperforms the benchmark.
An investor who bought in 2000 and listened to his broker‘s advice to hold on because “the market always comes back” would have seen massive fluctuation and periods of enormous loss. The question is this: did he “Hold,” or did he “Fold” at any point in time? If he held on, there would have been a lot of pain and anguish, often leading to a buy high, sell low effect.
Dalbar reports that from 1991 through 2010 the S&P 500 20-year average was 9.14%, while the average mutual fund investor earned 3.83%. In spite of the popularity of the Buy & Hold strategy, it does not take human emotion into account; most investors buy high and sell low. When the market is down or declining, people become afraid and freeze or sell. The opposite happens when the market is rising; people watch it rise, become more comfortable, and, believing that it is logical and safe, they actually buy triggered by an emotional decision based on Greed and Fear. As seen in the charts below of the DJIA and the Inflow/Outflow into US Equity Funds chart 1995-2011, the majority of capital inflows are near the tops of the DJIA and the majority of the outflows are near the lows. Buy & Hold is a bad idea, but buying high and selling low is worse.
Now that we know why Buy & Hold doesn’t work, let’s take a look at the other reputed benefit of MPT: diversification. Most equity portfolios are invested and diversified among the major indexes such as the NASDAQ, Russell 2000, S&P 500 and the MSCI EAFA (one of the major indexes for international holdings). The chart above shows the value of $1,000 invested in these indexes from January 2007 through December 2011. As with the S&P 500, we are not actually able to invest in these indexes; however, as many people do invest in no-load equity index mutual funds, this will give you an idea of what is going on. What we see is that there is an extremely high degree of correlation between these indexes, meaning that they really do move up and down together.
Using the S&P as the benchmark to judge correlation, we can see that these other major indexes move in similar fashion. A .92 signifies a 92% correlation, meaning that they move together. A 1 correlation means they move up and down in tandem.
Let’s take this a step further and look at how some well-known mutual funds are correlated to the S&P 500.
The chart above shows the growth of $1,000 invested in January 2007 through December 2011 among some of the most widely held funds from the “Large Funds” category on MSN Money . There is a very high degree of correlation to the S&P 500. This is actually exactly what they are supposed to do. The mutual fund manager of a large cap fund is supposed to buy large cap stocks and is generally 95 % to 98% fully invested in large cap stocks. The fund manager does not have the option to move the invested dollars of the fund to cash because his mandate is to own large cap stocks. That means that even if the fund manager knows in his heart that the market is going to plummet, he must stay almost fully invested in large cap stocks. This is why large cap funds go up and down with the market.
Now that we have looked at the most widely held Large Cap funds, let’s take a look at the best funds. Using the funds listed in the popular annual CNNMoney article titled”Money70: The Best Mutual Funds You Can Buy,” we compared the best Large-Cap funds to the S&P 500, as illustrated in the graph below.
Once again it looks as though there is a very high degree of correlation. Let’s look at the actual numbers.
The Vanguard Total Stock Mkt Idx Inv has a correlation of 1, meaning it is moving in tandem with the S&P 500. That manager is doing exactly what his mandate tells him. He is mirroring the S&P 500, which he does by buying S&P 500 stocks. If this does not seem difficult, it’s because it is not. There is actually no investment expertise going on in that fund. The correlations of .94 to .99 are a result of fees and of not owning an exact mirrored allocation of the actual S&P 500--but they are pretty darn close.
The point is that in the traditional investment world, there is no safety through diversification because the assets recommended to clients on the equity side have an extremely high degree of correlation. They move up and down together, and they have an even higher degree of correlation in times of crisis--when true diversification is most important.
If you are sitting across from a stock broker that tells you about the advantages of MPT, safety through diversification or Buy & Hold, smile politely, grab your hat and run away as fast as possible. MPT has been disproven because there is no safety in diversification of highly correlated assets. Then remember that Buy & Hold plus human emotion turns into Buy & Hope--which turns into Buy High and Sell Low. Your first step toward safety is to run away fast and find an advisor that shares this type of information.
For more retirement planning information from Mark Sherwin please visit www.sagecapitaladvisors.com.