Copyright 2002 by Investment Policy magazine. All rights reserved.
Is MPT the Solution -- or the Problem?
Malcolm Mitchell - July 2002
The proper choice among efficient portfolios depends on the willingness
and ability of the investor to assume risk. . . . If a greater degree of
uncertainty can be borne, a greater level of likely return can be obtained.
Harry Markowitz, 1959, p. 6.
To help investors determine the level of risk they're most comfortable
with, here's a statistically based risk-tolerance quiz.
Wall Street Journal, July 14, 2000
Bonds have a risk. Stocks have a risk. But their combined risk, when put
together in a portfolio, tends to be less than when they stand on their
Lebenthal & Co. radio ad, March 2002
Happiness is not a destination, it's a way of traveling.
Church display, New York, March 2002
Modern Portfolio Theory bestrides the investment world today like the
legendary Colossus. Its precepts dominate the education and training of
every professional investment manager; its key terms -- risk-return
tradeoff, diversification, expected stock returns -- frame virtually all
advice offered to non-professional investors. Indeed, so complete is
MPT's domination that we may forget how recent it is. While the set of
concepts itself is a product of many years' labor by many individuals --
the seminal paper by Harry Markowitz was published exactly 50 years
ago -- widespread adoption of MPT principles by the professional
investment community is barely 20 years old.
Our thesis is that exclusive and uncritical devotion to investment ideas
that can hardly be said to have stood the test of time is dangerous in
itself -- but especially so today. For the first time in more than 20 years,
the stock market has clearly stopped rising; broad indices are lower than
they were in 1998. MPT purists react to the investment wreckage of the
past four years by insisting that the theory itself remains valid, but that
some managers have misused it, out of either ignorance or greed, and
that the misuse has led many investors to form unattainable hopes. The
accusation may be true; many investors have certainly been misled. Yet
the problem of the future remains: correctly-applied MPT or no,
investors may lose money over the next four years as well -- or longer.
What's more, the potential losers now include a large and growing
number of working Americans with self-directed retirement accounts. At
least 40 million men and women participate in 401k plans, a legal entity
that didn't exist before 1980; their assets total over $1.5 trillion, even
after recent losses. The retirement benefits of these 401k-ers are not
guaranteed; their future is still at the mercy of the market. Yet MPT
advocates offer no help except to point out that most non-professionals
ignore the precepts of MPT and consequently miss the opportunity to
improve the long-term growth rate of their assets. Professionals seem to
be saying, "If only 401k-ers would behave more like us."
On the professional investment side itself, however, there are some
neglected questions that in our view undermine the continued reverence
paid to MPT:
First, has MPT actually worked for professionals? The theory's
ascendancy began in the late 1970s and was capped by the awarding of
Nobel prizes to its brightest lights in the 1990s. Coincidentally, this was
just the period of unprecedented gains in U.S. equities; the Dow Jones
Industrials average rose 10-fold. Has it been proven that the adoption of
MPT contributed anything to institutions' increased wealth over and
above what equity markets contributed?
Second, why have institutions -- pension, endowment, and foundation
funds -- paid virtually no attention to their own risk-adjusted returns at
the total fund level? Institutions judge their external managers by the
cornerstone of MPT, that is risk-adjusted measures, yet their own CIOs'
financial and career advancement is determined primarily by the fund's
total asset growth relative to comparable funds, not by the risk-adjusted
And finally, most to the point, why have we seen a universal rush by
corporations and public employers alike to switch employees from
guaranteed to non-guaranteed retirement plans? Doesn't that switch at
the very least cast some doubt on employers' confidence in their own and
their managers' MPT-based investment skills? (Portability and a
guaranteed benefit are not mutually exclusive, so claiming portability as
the impetus for the switch is no answer.)
The critical reality today is that no one has certain knowledge of what
investment markets will do in the future. But neither did anyone have
certain knowledge in 1928, or 1945, or 1972. So what is it that MPT has
changed? Do investors today really have a set of guidelines that, as MPT
advocates believe, for the first time tell us "how to manage our affairs so
that the uncertainties of human existence do not defeat us?"(1) In this
article we offer a contrarian answer to that question, hoping thereby to
provoke fresh discussion of the foundations of MPT. (Note (2) is for
Here is a brief summary of the article:
Section I -- Is Volatility Risky? -- looks at the "risk" that Harry
Markowitz found a means to measure and by so doing laid the
groundwork for all of MPT. We will argue that what professionals agree
is the "extraordinary intellectual density and originality"(3) of
Markowitz's Nobel prize-winning writings rests after all on his
redefining risk as volatility. That unsupported and unexplained
redefinition confounds what all investors previously thought of as risk --
and what non-professionals still think it is -- that is, the possibility of
Section II -- Diversification Is for Defense, Not Offense -- deals with
diversification, the second concept, after risk, whose importance
professionals claim was discovered by Markowitz. We will argue that a)
investors have always understood the reason for the warning, "Don't put
all your eggs in one basket," b) buying large numbers of equities is
neither the only nor necessarily the best method of diversifying, and c)
in any case, the MPT use of the term obscures the fundamental truth:
"While there are many valid reasons to invest in diversifying assets . . .
increasing the return of the portfolio is not one of them."(4)
Section III -- The Long Run: A Destination? Or a Receding Horizon? --
argues that the application of MPT creates a bias toward the expectation
of rising stock prices. That bias was supported by the unprecedented rise
in stock prices from 1980 to 1999. It is also encouraged by academic
studies that proclaim the wisdom of owning "stocks for the long run" --
even though in those studies the tough job of defining the long run in
practical terms is always fudged. We argue that statements such as,
"One dollar invested and reinvested in stocks since 1802 would have
accumulated to $11 million by the end of 1999,"(5) are dangerously
misleading to investors making decisions today.
Section IV -- Risk Is Not in Our Markets, but in Ourselves -- argues
that true risk, for professional investors and non-professionals alike, is
defined by the impact that a loss would have on their overall financial
health. Any advice that professionals offer to non-professionals,
therefore, ought to begin with the question: How much money can you
afford to lose? MPT-inspired studies of investor psychology and similar
studies in "Behavioral Finance" can't explain when an investor is making
a "right" decision or a "wrong" decision, because they ignore the varying
impacts that the same loss has on different investors. We argue that
investors' total wealth should influence their investment decisions far
more than their age or profession, or aggressiveness or timidity.
In our Conclusion, we return to some time-honored advice for investors
that MPT claims to have superseded, and we offer some new
suggestions. We argue that for most investors happiness is a destination -
- ending up with more money than they started out with -- and that
reaching their goals depends more on making appropriate asset class
choices than on correctly applying MPT. Indeed, the developers of MPT
may have had a different destination in mind all along. A now-famous
review of "What Practitioners Need to Know" in the Financial Analysts
Journal seems to suggest just that: "The value of the contributions of
these Nobel laureates [Markowitz, Sharpe, Modigliani, and Miller] does
not depend on the degree to which their theories hold in an imperfect
market environment. It depends, rather, on the degree to which they
changed the financial community's understanding of the capital
Section I. Is Volatility Risky?
Risk: the possibility of loss, injury, disadvantage, or destruction.
Uncertainty: the state of being uncertain . . . something doubtful or unknown.
Variability: the fact of being variable, [being] able or apt to vary or change.
Webster's Third New International Dictionary
In 1970, John O'Brien, later of Leland O'Brien Rubinstein fame,
published an article in the Financial Analysts Journal that is recognized
as the first general exposition of the new "market theory." In a section in
which he explained the terminology of the new theory as applied to
performance measurement, O'Brien made a parenthetical comment:
In looking back at performance the term "uncertainty" seems better
replaced by "variability", however for consistency with the market
theory we will continue to use the term "uncertainty". [punctuation
as in original](7)
With his timid suggestion, O'Brien in fact spotted the obvious difference
in meaning between two words that Harry Markowitz had used
interchangeably in the 1950s. When we look at past performance, there
is no uncertainty; we know precisely what happened and how much
variability there was. When we look forward, there is, by definition,
uncertainty. Yet Markowitz used both words as synonyms for "risk." In
the index to his 1959 book, the entry under Variability is, "see Risk."
The entry under Uncertainty is, "see Risk."(8)
Needless to say, O'Brien's suggestion was never taken up by later
developers of MPT, and Markowitz's equation of risk with variability
and uncertainty has never been challenged. It needs to be.
The fact is that Markowitz did not find a way to measure the risk that
investors care about: the risk that arises from an uncertain future, the risk
that things will turn out to be worse than we expect. He simply ignored
that kind of risk and focused instead on variability -- or, to take the term
more commonly used today, volatility. Instead of measuring risk,
Markowitz demonstrated how to measure volatility in a portfolio. Why
volatility? One obvious reason is that volatility is measurable, whereas
uncertainty is not.
Another possible reason for calling risk volatility is that it does share
one characteristic with uncertainty: both terms refer to a spread of results
around a median. What concerns investors, however, is not the spread of
results that occurred in the past, but the expected spread in an uncertain
future. Interestingly, the word "uncertainty" did not appear at all in
Markowitz's 1952 article, but by 1959 he apparently realized the
importance of trying to make volatility seem more like uncertainty.
Despite the obviousness (in our view) of the preceding argument, the
triumph of MPT has had this result: whenever the word "risk" appears in
investment literature or discussion, it means "volatility" -- whether the
writer or speaker is fully conscious of that meaning or, more likely, isn't.
Among the many millions of investors today, whether professional or
non-professional, there is probably a minuscule number who both
understand that MPT risk is volatility and agree that volatility is what
The following passage, written by a professional who certainly does
understand, perfectly illustrates the MPT meaning of risk. The passage
appears in a fine explanation of how the discoverers of option pricing
theory arrived at their insight, but that doesn't diminish its relevance for
our purposes. We cite the passage as evidence that the volatility that
MPT calls risk isn't risky for investors.
Consider two stocks, one much riskier than the other, but each selling
for $20 a share. To simplify matters, assume that neither pays a dividend.
The market believes that the less risky stock will be selling for $32 five
years from now, or within a range of, say, $30 to $34, for an average
expected return of 10 percent a year. The market believes that the riskier
stock will be selling for $40, within a much wider range of $32 to $48, for
an average expected return of 15 percent a year.
But the two stocks are selling at the same price of $20 today because
investors have taken into consideration the differences in risk, even though
the expected future prices of the stocks differ widely. The higher risk
cancels out the higher expected return and leads to the same price today for
the risky stock as for the less risky stock.(9)
We would argue that on the given assumptions the conditions described
in this passage could not hold -- at least not for more than an instant.
What possible problem could the greater volatility of the more "risky"
stock pose for an investor, when the least of its expected spread of
results over five years is $32, and the least of the less risky stock's
results is $30? Would any investor refuse the chance to more than
double his or her money, simply because that chance exists? Given the
choice between the two stocks in this passage, investors would always
choose the "risky" stock, and thus push the price of that stock above the
price of the other.
In the real world, the risk that investors face with either stock is the
possibility that an early move of their $20 investment might be to $15,
instead of toward "expected [higher] future prices." If that were to
happen, what investors would begin to fear is not volatility but the
possibility that they were wrong about the direction of their
expectations. In deciding between the two stocks, investors might indeed
consider the stock with a wider range of expected future prices more
risky than the one with a narrower range because the wider range
includes a greater possibility of the stock going to $15 at some point.
But that isn't a scenario the passage considers; nor is that the MPT
definition of "risky."
There is actually one kind of risk that may result from volatility. If the
more volatile of the two stocks described does rise quickly to $35 or
$40, investors might push their expectations still higher and believe they
will have even more money to spend than they originally planned -- for
example, on the proverbial daughter's wedding. If the investment then
reverts to $32 on the week of the wedding, they might find themselves
short, despite having a 60% profit on their $20 investment. That risk,
however, arises not from the range of expected future prices but from the
way some investors respond to paper wealth. And again, MPT has
nothing to say about that kind of risk.
In sum, we believe that defining risk as volatility is irrelevant to
investors' real experiences, and worse, that it obscures the true definition
of investment risk as the possibility of losing money. (In Section III we'll
return to the reasons why MPT discussions typically ignore the risk of
Section II. Diversification Is for Defense, Not Offense.
Until 1952 . . . the relation between the risk and return of a portfolio had not
been considered at all. Economist John Maynard Keynes, an astute
individual by any standards, viewed the best investment strategy as one
where you put all your money in the few stocks about which you felt
favourably, without any regard to diversification.
Raman Uppal, Associate Professor of Finance, London
Business School, in the Financial Times, June 4, 2001.
The well-known investor Gerald Loeb railed against diversification in 1935.
. . . "Once you obtain confidence, diversification is undesirable," Loeb
declared. Diversification "is an admission of not knowing what to do in an
effort to strike the average."
S.L. Mintz et al., Beyond Wall Street, p. 160.
Diversification does not ensure a profit or guarantee against loss.
Stages magazine, 2002
For some obscure reason, John Maynard Keynes and Gerald Loeb are
singled out by MPT advocates as proof that pre-Markowitz investors did
not understand the importance of diversification. We'll show below that
both men in fact held sensible and useful ideas on diversification, but
our first job is to try to explain the silly argument that MPT discovered
diversification. Clearly, intelligent people have long understood the
intended benefits of diversification. The danger of risking everything in
a single investment or on a single roll of the dice -- of putting all your
eggs in one basket -- is as familiar as children's fables and has appeared
in world literature for at least 500 years. What, then, could MPT
We believe that MPT confounds the age-old purpose of diversification,
just as it confounds the true meaning of investment risk. Diversification
has always implied -- and still does for most investors -- spreading your
investments among several securities (or asset classes) so that if one of
them goes unexpectedly down a profit in the others may offset the loss.
In other words, diversification is a response to investors' uncertainty
about the future, to the unavoidable risk that any expected profit may
turn out to be a loss.
Since risk is redefined in MPT to mean not the possibility of loss but
simply volatility, we might expect that the role played by diversification
is also redefined. Indeed, it turns out that the crucial purpose of
diversification in MPT is to fine-tune the balance between a portfolio's
expected return and its expected volatility. The goal is to create
"efficient" portfolios that both maximize expected return and minimize
expected volatility. We have argued that volatility doesn't concern
investors. Markowitz not only said it should, but that it should be
equally as important to investors as the hoped-for return. "The investor,"
he wrote in 1952, "does (or should) consider expected return a desirable
thing and variance of return an undesirable thing [italics in original]."
The main thrust of Markowitz's writings in the 1950s, after defining risk
as volatility, was to develop the mathematics of diversifying into
appropriate securities in order to produce "efficient" portfolios, that is
portfolios with the highest expected return at any given level of expected
volatility. Structuring these efficient portfolios has become the holy grail
of MPT, and diversification, properly used, is the principal tool in the
quest. No wonder MPT advocates claim that pre-Markowitz investors
didn't understand diversification; not having the benefit of learning that
risk is volatility, they could hardly have understood how diversification
is meant to adjust a portfolio's risk-return profile.
A disturbing, albeit unintended effect of MPT's re-conception of
diversification is that it appears to be used to enhance return. In MPT
practice, portfolios are diversified into selected securities because of the
way the securities' expected returns and volatility combine with each
other (through their correlations) to produce efficient portfolios. Yet
because the goal is maximum expected return at a fixed level of
volatility, it can seem that, with volatility fixed, diversification enhances
In reality, sensible investors, including Keynes and Loeb, have always
understood that diversification reduces their expected return as a
condition of its protecting them against unexpected loss. The reason we
don't put all our assets into the one "best" security or asset class, that is
the one with the highest expected return, is not that we believe we can
make more money with several. Quite the opposite; we invest some
assets in a second-best security because we're willing to accept less
money than we would make if we are right about the best, in order to
protect against our being wrong. It isn't that we change our belief about
the investment we are most certain of; we simply act on the possibility
that in an uncertain world even that one may disappoint us.
Keynes and Loeb took very different approaches to solving this dilemma
of uncertainty, but they agreed on one important truth: investors are
better off acting on full and good knowledge than on scant knowledge.
For Keynes, who advised insurance funds and other asset pools that
remained fully invested, the solution was to buy only those investments
about which his knowledge was "adequate" -- even if that meant the
amounts invested in each one were large. In the passage usually quoted
to prove he didn't understand diversification, he explains:
I am quite incapable of having adequate knowledge of more than a very
limited range of investments. Time and opportunity do not allow more.
Therefore, as the investable sums increase, the size of the unit must increase
[i.e., the amount invested in a single stock must grow]. I am in favour of
having as large a unit as market conditions will allow. . . . My objection [to
"good examples" of potential capital profits] is that I have no information on
which to reach a good judgment, and the risks are clearly enormous. To
suppose that safety-first consists in having a small gamble in a large number
of different directions of the above kind, as compared with a substantial
stake in a company where one's information is adequate, strikes me as a
travesty of investment policy.(11)
That seems to us advice that displays a thorough understanding of
diversification and is eminently sensible besides. Warren Buffett could
hardly have said it better.
Gerald Loeb acted as a stock broker for individuals and therefore took a
different approach to the dilemma of uncertainty. He advised investors to
diversify by holding back cash (in short-term Treasury bills) and
investing only on "convincing" knowledge. In the same passage in
which he dismissed diversification as "an effort to strike an average" --
which, by the way, is precisely what broad diversification is -- he
explains that his policy includes "holding one's capital uninvested [in
stocks] for long periods of time," since "bargains . . . are not available
except occasionally." Here is his explanation of why he prefers a few
large stock investments to many small ones:
[A] few large holdings may total only 30% of funds available at the
moment. . . . Confining oneself to situations convincing enough to be
entered on a relatively large scale is a great help to safety and profit. One
must know far more about it to enter the position in the first place. . . . A
large number of small holdings will be purchased with less care and
ordinarily allowed to run into a variety of small losses without full
realization of the eventual total sum lost. Thus over-diversification acts as a
poor protection against lack of knowledge.(12)
Again, eminently sensible advice from a pre-MPT investor. It suggests
to us that MPT adds to an investor's understanding of diversification
only in the context of the theory itself, that is, only if the investor's
primary goal is to hold an efficient stock portfolio, rather than to make
We'd like to give the last word on pre-MPT understanding of
diversification to Benjamin Graham and David Dodd, whose 1934 book,
Security Analysis, quickly became, and remains, the bible of non-MPT
investing. Not the least impressive feature of their book is that it
appeared in the depths of the Great Depression that followed the 1929
stock market crash, and yet the authors advised investors not to give up
on America's corporations:
On the assumption that . . . our national wealth and earning power will
increase [and be reflected in] the increased resources and profits of our
important corporations . . . common stock [properly selected] should on the
whole present the same favorable opportunities in the future as they have for
For Graham and Dodd, the investor's method of selecting stocks is
critical, since the method determines whether the purchase is an
"investment" or merely a "speculation." A stock purchase can qualify as
an investment when the investor has carefully analyzed the price of the
stock versus the value of the company. Yet it is still not an investment if
only that one stock is bought:
While [diversification] had always been regarded as a desirable element in
investment, our formulation goes much farther in that it holds
diversification to be an integral part of all standard common-stock-
investment operations. In our view, the purchase of a single common stock
can no more constitute an investment than the issuance of a single policy on
a life or a building can properly constitute an insurance underwriting.(14)
Section III. The Long Run: A Destination?
Or a Receding Horizon?
If you've set aside adequate funds for your short-term needs, time is on your
side and the stock market has historically been the place to be. And when I
say long term, I don't mean three weeks from Wednesday. I mean a
minimum of five, 10, or 20 years.
Peter Lynch, in Stages magazine, Spring 2002, p. 24.
History backs me up here: The long-term trend of the stock market in the
United States has always been up. . . . "One dollar invested and reinvested
in stocks since 1802 would have accumulated to $11 million by the end of
1999," [Jeremy Siegel] says.
Charles Schwab, You're Fifty -- Now What?, p. 14.
Investing in stocks seems to be a game in which all the players are on
one side. Everyone wants prices to rise; short-sellers are a rare species.
Even the old bear raids that drove stocks down became impossible after
1933, when short sales were required to be on an uptick -- that is, at a
higher price than the stock's previous trade. Yet bull raids that inflate
stock prices are with us still, as revelations about analysts'
recommendations are making painfully clear.
All in all, it's a wonder that the stock market ever goes down. Indeed,
according to most MPT advocates, in the long run it doesn't. The belief
that stocks produce a positive return to investors over time is so deeply
ingrained in investment thought today that it's nearly impossible to
consider the belief objectively. Nonetheless we're going to try. We'll first
point out that both MPT practice and the 20-year super-bull market
encourage the expectation of future stock profits. Then we'll look at the
claim that stocks increase investors' wealth over time, and we'll ask:
What stocks, what investors, and what time?
The fundamental MPT activity is the attempt to structure efficient
portfolios by choosing securities or asset classes with specific expected
returns, volatility, and correlations. As no investor considers adding to
his or her portfolio an investment that is expected to lose money, MPT
research is based on investments with only positive expected returns.
This was true for the studies that Markowitz produced in the 1950s, and
it continues to be true today. As we showed in Section I, the uncertainty
that MPT claims to have overcome is investor uncertainty about a range
of positive expected returns, not investor uncertainty about making or
It happened that during the 20 years of MPT's ascendancy throughout
the investment world, assumptions of positive returns from stocks were
fully justified. From 1980 to 1999, the S&P 500 grew more than 12-fold;
in only three of the 20 years did the index record small losses, and in
each case the losses were more than made up the very next year.
In historical terms it was a unique 20-year run, and its coincidence with
the adoption of MPT is striking. Most reasons given for the surge in
stock prices are independent of MPT: new technologies, new corporate
behavior, improved inflation-fighting techniques -- in short, a new
economy. Yet some MPT advocates argue that the new investment ideas
themselves, by generating greater confidence in building portfolios,
improved capital allocation, more investor patience in down periods,
etc., also had a role in sustaining stock prices.
Whatever was pushing stock prices higher for so many years, it seems to
have run out of steam. The S&P 500 is lower now than at the end of
1998. There has been enough damage to stock values to make continued
confidence at least suspect, and the possibility cannot be dismissed that
the stock market has reverted to one of its recurrent long periods -- 10
years or more -- of moving sideways. In short, compared to the full
historical record that we now have on economies and markets, the past
20 years are too brief a period, in our view, to prove the lasting validity
of either MPT or a new economic paradigm.
When we turn to that long historical record, however, stock enthusiasts
seem to be on firmer ground. Leaving aside the patchwork involved in
creating centuries-long statistics, there are now accurate and consistent
measures of over 75 years of stock market history, and it does seem to be
true that over all that time stocks have provided an average annual return
to investors of some positive percentage (the precise number is irrelevant
to our discussion). Surely, investors can be confident of the future on the
basis of such a long history. Or can they?
Consider, first, what the history is of -- namely, indices of stock prices.
The best the record can show, therefore, is that an investor who owned
the index over the whole period made money. Unfortunately, investors
weren't able to buy an index -- indeed didn't conceive of buying an index
-- until almost 1980. Forgetting that fact can lead to some questionable
arguments, for example the following defense of John J. Raskob, whose
infamous advice to buy stocks appeared just months before the 1929
crash, in an article entitled, "Everybody Ought to Be Rich:"
The conventional wisdom is that Raskob's foolhardy advice epitomizes the
mania that periodically overruns Wall Street. But is that verdict fair? The
answer is decidedly no. If you calculate the value of the portfolio of an
investor who followed Raskob's advice, patiently putting $15 a month into
stocks, you find that his accumulation exceeded that of someone who placed
the same money in Treasury bills after less than four years! After 20 years
[that is, by 1949], his stock portfolio would have accumulated to almost
$9,000, and after 30 years [by 1959], to over $60,000. Although not as high
as Raskob had projected, $60,000 still represents a fantastic 13 percent
return on invested capital [our italics], far exceeding the returns earned by
conservative investors who switched their money to Treasury bonds or bills
at the market peak.(15)
Here's the problem with this history. Since no index funds were available
at the time, the only way a $15-a-month stock investor starting in 1929
could have accumulated $60,000 by 1959 was to make one stock pick
every month for 30 years, then to decide whether to hold each purchase
through its ups and downs over all the remaining years or to switch it at
some time to another stock, and in all those thousands of decisions to be
right often enough and wrong seldom enough to emerge with a
"fantastic" return that professionals would have envied. Such a "patient"
30-year feat can't be proven impossible, just as you can't prove that an
infinite number of monkeys using infinite typewriters over infinite years
wouldn't produce Hamlet. It just seems to us quite unlikely.
The reality is that, looking back from today to 1926 (the initial year of
the most authoritative return series), we have no idea whether investors
made money or didn't for over two-thirds of the period studied. Nor do
we have any idea of what would have happened if investors had been
able to buy an index in those years, instead of only individual stocks. In
our view, the record for the years prior to 1980 can make for interesting
academic analyses but is hardly the stuff of safe advice for investing real
On the other hand, we do have a good idea of the investor base and the
nature of their activities over the long history. And again, profound
changes during the past 15 to 20 years give reason to wonder whether
the full record can still be relevant. The changes are easily recited: huge
numbers of new investors, not just absolutely but relative to the total
population; an explosion in the number and variety of mutual funds and
other available investment vehicles; new sources of investable assets,
changed investor goals, and a revolutionary social context for investing -
- that is, an unprecedented relationship between stock market
expectations and retirement planning on a society-wide scale. What's
more, all of these changes have coincided with huge growth in total
stock market capitalization as a percentage of U.S. GDP -- that is, a huge
increase in the impact of stock market movements on the health of the
overall U.S. economy.
In short, the investment world has become a vastly different place in the
last 25 years from what it had been in the previous 50 years. The ability
to look through all of the changes and see only an average annual rise in
stock prices over the 75 years is a symptom, in our view, of an advanced
and dangerous case of tunnel vision.
Nonetheless, let's grant that 75 years of stock market history may be
reasonable evidence of what lies ahead. Let's further grant that the recent
creation of index funds means that now "matching the market is
sufficient to achieve the superior returns that have been achieved
through stocks over time."(16) There still remains a crucial question:
Over what time? And the answer to this question is one that stock
enthusiasts always fudge. Consider Peter Lynch's definition of the long
term as "a minimum of five, 10, or 20 years." We want to ask, Well,
which is it? If the long-term investor can expect to be rewarded in five
years, what do the 10 or 20 years imply? On the other hand, if the
investor may have to wait "a minimum of 20 years," why not say just
that? It seems redundant to add the "minimum of five or 10 years."
The explanation is that proponents of long-term investing claim to know
what will happen in the future, but they say they can't be sure of the
timing. In our view, however, stock enthusiasts, like messianists,
purposely fudge the "when" in order to deflect doubts about the
occurrence itself. We would argue that, at least for investors, there is no
such thing as a sure occurrence at an unspecified time in the future,
because the basic goal of every investor is to enjoy an increase in assets
in time. Sensible stock investors, professionals or non-professionals,
don't expect their reward next week or next quarter, but no one is content
with the idea of waiting 20 years. The common reaction of all investors,
if their expectations aren't realized in five or ten years, is to begin
questioning the validity of those expectations, whether for a single
security or for an asset class.
There's a simple truth: neither Peter Lynch nor anyone else knows that
investors will enjoy a positive return from the stock market, not over the
next five years or the next 10 years or the next 20 years, just as no one
knows what the market will do next month. In the face of uncertainty
about future stock prices, the best that stock enthusiasts can offer is to
assign a measure of probability to various potential scenarios, based on
statistical analyses of 75 or more years of stock market history. But
there's a better approach for investors than playing probabilities, and that
is to look at stock market prices versus stock market value. We'll refer to
that approach in our Conclusion.
Even if higher probabilities for certain stock market outcomes can be
proven, however, such proofs, as we will argue in the next section, are
not equally helpful to all investors -- not even, as MPT-inspired advisors
would have it, to all investors of the same age, income level, and
emotional stability. The risk posed to investors by any chance that their
assets will shrink rather than grow, over any time frame, is not
determined by the probabilities of market results, but by the ability of
individual investors to remain financially healthy despite the shrinkage.
Section IV. Risk Is Not in Our Markets,
but in Ourselves
Markowitz once pointed out to me how someone with "pathological risk
aversion" would behave. . . . Offered a choice between a certain gain of 5
percent and a 50-50 gamble of coming out with either nothing or infinite
wealth, the pathologically risk-averse person would choose the 5 percent.
Peter Bernstein, Capital Ideas, p. 59
Studies in behavioural finance have shown that investors are far more
distressed by prospective losses than they are made happy by equivalent
Greg Elmiger, in the Financial Times, June 11, 2001
401k and similar plans are designed to give ordinary people economic
security in retirement by encouraging them to mimic the portfolio strategies
long pursued by the wealthy. But little attention is usually paid to the fact
that the wealthy, because of the overall level of their assets, have less reason
to worry about losing substantial amounts in a market decline.
Robert J. Shiller, Irrational Exuberance, p. 217
We have argued so far that MPT shifted the focus of investment risk
from potential losses to volatility, and that with a little help from
academics and from 20 years of unprecedented stock profits, it
encourages investors to entirely ignore the risk of losing money.
Nonetheless, despite MPT's monopoly of the advice offered to non-
professionals, many investors still view stock market investing with
some skepticism. This has become a gnawing puzzle to MPT advocates,
who take any investor's failure to properly balance return and volatility
very seriously. Markowitz's charge of "pathological risk aversion" is
only an extreme example of how MPT commonly ignores an investor's
overall financial situation and the potential impact on that situation of
any particular choice -- whether it's avoiding a loss or taking "a certain
gain." Most of us would consider a man on the verge of starving to
death quite sane to eat a single ham sandwich rather than take a 50-50
gamble on a week of steak dinners, or nothing.
Attempts to address the supposed puzzle of investors' risk aversion led to
the development of a new academic discipline called Behavioral
Finance, in which risk aversion is more realistically called "loss
aversion." We're going to quote at length from one discussion, because it
is so revealing of how the discipline -- whatever its contributions to
economics and finance studies may be -- has been misapplied in the
Much of the credit for articulating the concept of loss aversion and
exploring its implications goes to Richard Thaler [Professor of Economics
and Behavioral Science at the University of Chicago's Graduate School of
Business]. Thaler first observed the phenomenon of loss aversion as an
unintended consequence of his dissertation on the value of human life. "I
was trying to estimate how much you had to pay people to get them to take
risky jobs," Thaler says. "The economist's approach is to study a lot of
statistics and estimate how much more people get paid in risky jobs."
Instead of building a model based on voluminous statistics, Thaler started
asking people questions -- an approach his thesis adviser had frowned on.
According to statistical estimates, the value of saving one life would
be somewhere in the range of one million to two million dollars. But Thaler
asked two questions, not one. First he asked, "Suppose you were exposed to
some risk, a one-in-a-thousand chance of dying next week. How much
would you pay to avoid that risk?" A typical person gave one thousand
dollars as the answer.
Then Thaler turned the question around. "How much would you
require to accept a risk with a one-in-a-thousand chance of dying?" he
asked. "According to economics," Thaler explains, "those two questions
should be more or less the same." Both ask the value of a life in the face of
one chance in a thousand of dying. "But people don't think of those
questions as the same," he says. "The very same persons who would say
they'd only be willing to pay a thousand dollars to get rid of a risk would
have to be paid fifty thousand or two hundred thousand to take a little bit
These inconsistent responses puzzled Thaler. . . . In the stock market,
loss aversion tends to cloud investment decisions. "When people are
thinking about investing . . . ," Thaler says, "they think more about losses
than they do about potential gains. So whenever I talk to investors about
how they should be investing, say, for retirement, if they take a very
cautious attitude and say, 'This is my retirement savings, I can't afford to
lose,' " Thaler then asks, "Have you thought about how much you are losing
by not investing that money in the stock market?" [italics in original](17)
One hardly knows where to start in pointing out what's wrong here.
There is, first, a startling absence of human understanding and
compassion in any suggestion that the two value-of-life questions
"should be more or less the same." On the one hand, most people live on
a limited budget and are therefore limited in what they can pay for
anything, including the chance to survive an unavoidable life-threatening
risk. On the other hand, most people, at least among the subjects of
Behavioral Finance studies, manage to live decently on their limited
budgets, and while some may be willing to change jobs in order to
improve their lifestyle, it would take a whole lot more than just increased
income to make them willingly put their lives at risk. Indeed, it is hard to
imagine a circumstance in which any normal person would treat the two
Even more startling, however, and also more relevant to our investment
discussion, is the failure of both Professor and commentator to realize
that there is no such thing as "a typical person" when it comes to placing
a value on avoiding a life-threatening risk or taking one on. Everyone
will evaluate the situation in the context of his total wealth and financial
options. In the real world there is always a wide spectrum of responses
to the same risk. Even kidnappers have figured that out.
Similarly, there is no typical investor, not even a typical 40-year-old,
moderately aggressive investor. There are only investors of varying
financial means -- varying in terms of family wealth, income, net fixed
assets (home value, car, etc., minus debts), and secure investments
(Government bonds, bank accounts, etc.). The total of these forms of
wealth determines what kind of investor an individual can be; it
determines his or her answer to the classic pre-MPT question, How
much can you afford to lose?
We would argue that neither MPT nor the new business of investing
retirement assets has diminished the importance of that question. Quite
to the contrary, the attempt to secure critical retirement benefits through
long-term investments ought to generate even greater attention to what
will happen if those investments don't perform as expected -- if investors
don't just make less over time than they hoped but actually lose some of
their own accumulated savings. Every investor's first job is to determine
how that possible scenario would impact his or her overall financial
As for Thaler's final question -- "Have you thought about how much you
are losing by not investing that money in the stock market?" -- we would
point out that hucksters always try to deflect attention from potential loss
by emphasizing potential gain: Think what you can do with all that
money; Think what you are giving up by not playing. The gambler's
sickness is to picture so clearly what he might win that he comes to
believe that he will win. He imagines that he is actually losing money
when he doesn't play. That's a true psychological illness that should
hardly be encouraged among investors.
Simply put, Wall Street shapes Main Street.
Peter Bernstein, Capital Ideas, p. 6.
Uncertainty is a salient feature of security investment.
Markowitz, 1959, p. 4.
Samuel J. Palmisano, chief of I.B.M., says investor uncertainty is holding
back the stock market and business investment.
New York Times photo caption, June 2, 2002.
In times of crisis, money moves from weak hands to strong hands.
Wall Street maxim.
We've shown that MPT's claim to have solved the dilemma of investor
uncertainty doesn't hold water; we've also shown that investors can't
expect to make money from stocks merely, as it were, by being there. On
what basis, then, can sensible people make reasonable and reasonably
promising investment decisions at all?
In this concluding section, we'll first reemphasize the goals that investors
should be trying to reach. We'll also consider the assumptions investors
make, either implicitly or explicitly, that lead them to believe a goal is
achievable. Finally, we'll list some initial steps for non-professionals to
follow, given the arguments we've made in this article.
It may seem obvious that investors' goals should be to make money, but
for several reasons we need to dwell a bit on the point. In the first place,
one of the central MPT concepts dominating the investment world, both
professional and non-professional, is that a return, that is, the amount of
money made, is only as good as the (low) volatility that accompanies it.
We've argued that this is a misleading concept and that investors should
focus on making money. Indeed, Chief Investment Officers of pension,
endowment, and foundation funds compete among themselves not on the
basis of "risk-adjusted" returns but on the amount of money they make
for their funds. The reason, of course, is that the more money the fund's
investments return, the more secure is the fund's ability to pay out. In the
case of a defined benefit pension fund, the higher the return the less the
fund's corporate sponsor will have to contribute.
There are additional aspects of the institutional focus on making money
that non-professionals also need to understand if they hope to make
sense of the MPT-based advice they hear. The rewards that professionals
receive are based not on the absolute return of their fund but on its
comparative return. As long as the CIO is doing better than his
counterparts in other funds, his career and earnings are safe. This is true
also for managers of the mutual funds that invest non-professionals'
assets. If a mutual fund actually loses money, but loses less than
competitive funds, the fund manager is rewarded, and the fund company
boasts of the fund's success to its holders and prospects.
This seeming anomaly of managers being rewarded for losing money
arises naturally from the fact that managers must invest their funds'
assets; they can't, like Gerald Loeb, remain uninvested until the right
security comes along. Furthermore, every manager is given a
benchmark, that is an index of a specific group of securities, and is
expected to produce the best return he can through investing in those
securities -- best, that is, compared to both the benchmark and to other
All of these features of institutional investing have both affected, and in
turn reflect, the development of MPT. It's not surprising, therefore, since
we have questioned the foundations of MPT, that the practical lessons
we believe non-professionals should draw from the institutional world
regarding the goal of making money are mostly negative lessons. When
you move from the business of investing other people's money to the
problem of investing your own money, most rules change.
Principal among the lessons is that individuals, who can choose to invest
or not invest, should not be happy to lose money; nor should losing less
than their neighbors ease their unhappiness. It follows, however, that
individuals should be happy if they make money, even though they make
less than their neighbors.
What we have said so far suggests that the proper goal for non-
professionals is a positive absolute return, taking into consideration the
investor's total financial situation -- that is, how much the investor can
afford to lose. We now have to explain how the goal should be derived,
not from promises or dreams, but from realistic assumptions about the
investor's own investment skills and the returns that are achievable with
The fundamental, mostly unrecognized assumption that investors make
is that by putting their money out -- which is what investing simply is --
they should receive more back. When applied to bond investing, the
assumption can make sense. A corporation (or a government entity)
presumably puts investors' money to work and thereby earns more
money (or generates more tax revenue), some of which it returns as
promised to its bond investors. The U.S. government always has the
taxing power to pay positive returns to investors, so at least in the case
of Treasury bonds, the assumption of making money is fully justified.
When we turn to stocks, however, investors' assumptions become more
complicated, especially since corporate dividends are now so
inconsequential a part of what investors expect to earn. This
downgrading of the importance of dividends is a relatively new
phenomenon. In fact, until the late 1950s stock investors had always
expected a higher return from dividends alone than was available from
the interest on bonds. (In another article, we'll deal with the profound
implications of the disappearance of stock dividends.)
If not for dividends, then, why do investors today assume that a stock
purchase will produce more money than they put in? In the case of a
company's first sale of stock -- its initial public offering (IPO) -- there is
a presumption that, as with a sale of bonds, the company will use the
money received to grow and become more valuable, and thus the price
of the stock will rise. There are a number of real problems with this
assumption, as the last five years of NASDAQ history shows, but IPOs
are so small a percentage of total stock investments that they aren't worth
There can be only two reasons why an investor today assumes he will
make money on a stock purchase: either 1) he believes that regardless of
the price he pays, another investor will be willing to pay a higher price;
or 2) he believes that he has deeper understanding of the value of the
company than the investor who sold him the stock, and that the seller
and others will realize later what they missed and want to buy the stock
then at a higher price. The first assumption -- which Wall Streeters call
"the greater fool theory" -- is clearly not one that a reasonable investor
wants to make. The second, we would argue, is a valid approach
(Warren Buffett showed it works), but only for investors who will
devote the time and resources necessary to study each company and try
to develop the deeper understanding.
Turning to index fund investing, what are the assumptions that investors
make? Let's consider first a new category of index funds that represent
subsets of the full stock universe: large capitalization funds, small
capitalization funds, value stock funds, growth stock funds, etc. These
funds exist in order to allow investors to make choices among groups of
stocks. Thus they are bought and sold on the same assumptions as are
single securities: in order to expect to succeed, sensible investors have to
assume they have the same deeper understanding of the group of stocks
as they had of a single security.
Let's consider now a broad index fund that does capture the movement
of the universe of stocks. We argued in Section III above that an investor
cannot be assured of making money in such a fund over any reasonable
time frame merely by being there. We can now point out that since the
level of an index fund is merely an aggregate of the prices of all
individual securities, there are the same two reasons for investors to
expect to make money in an index fund as in one or more securities.
They either believe in the greater fool theory or believe they understand
something that is being missed by sellers of individual stocks at current
Their deeper understanding in this case may be about the new economy,
or changing valuations, or other factors. Nonetheless, we would argue
that making a reasonable decision on the assumption of deeper
understanding of any of those factors requires at least the same devotion
of time and resources as is necessary for a single stock purchase. (We
will explain the application of the price-earnings ratio to index fund
investing in another article; we'll show that taking a p/e approach to
investing in the whole economy is not difficult, yet it greatly increases
investors' chances of success.)
We'll now sum up what we have argued in this article by suggesting
some initial steps that non-professional investors ought to take. This is
not at all a full program of investment advice, but our suggestions will at
least save investors from losing more money than they can afford to.
1. Recognize that a positive return is always possible. U.S. Treasury
bonds, for example 10-year bonds, offer good returns with no risk. The
argument that buying bonds leaves you open to the risk of loss through
inflation -- an argument that comes mostly from stock enthusiasts -- has
two answers. First, inflation is not endemic to human life, not even to a
growing economy. The hyper-inflation suffered in some countries in the
20th century, and to a lesser extent in the U.S., was historically an
aberration. Indeed, stock enthusiasts themselves base their optimism
importantly on their belief that the new economy has conquered
Second, there are simple methods of buying Treasury bonds
periodically -- and holding them to maturity -- that offer some protection
against any future inflation by generating higher interest if inflation
rises. (In another article we will describe one study that shows the results
of this "laddering" investment method.)
2. Treat all investments, whether in a 401k account or elsewhere, as
part of your total financial situation. There is nothing special about your
401k, except that it enables you to save money pre-tax. But there should
be no difference in your mind between your 401k savings and your other
assets, including the net value of your home, life insurance, and other
property. To the extent that you will depend on your savings for
retirement benefits or other necessary expenditures, consider them
savings that you cannot afford to lose, and keep them in "laddered"
3. In contemplating potential returns from any stock investments,
over any time frame, include the possibility of losing money. Feel
confident only to the extent that you can lose some of your savings
without a significant impact on your lifestyle or your retirement benefits.
4. If you cannot, or will not, spend several hours every day studying
stock investments, buy only a broad index fund, not individual stocks,
and not a "value stock" fund or any other subset fund.
5. Recognize that with any stock investment today, including a stock
index fund, you cannot make money unless someone else will find a
reason to buy the investment later at a price higher than you paid. Ask
yourself why someone should pay the higher price. (We'll have much
more to say about the Graham and Dodd concept of "investing" versus
"speculating" in our future article on the price/earnings ratio.)
6. Finally, keep a record of the total value of your 401k fund (or any
other investment assets) on a regular basis. If you haven't done that so
far, start today. By consistently maintaining the record over the years,
you will be able to test your progress on the two questions that matter to
you: whether you are on track to achieve the goals you have set, and
how much your investments have added to your fund over and above
your own and your employer's contributions.
- - - - - - -
Peter L. Bernstein, Capital Ideas: The Improbable Origins of
Modern Wall Street, The Free Press, New York, 1992.
This is an indispensable book for understanding the origins and
development of MPT.
Benjamin Graham and David L. Dodd, Security Analysis: Principles
and Technique, McGraw-Hill Book Company, Inc., New York, 1934.
John Maynard Keynes, Letter to F.C. Scott, February 6, 1942, in
Charles D. Ellis and James R. Vertin, Eds., Classics: An Investor's
Anthology, Business One Irwin, Homewood, Illinois, 1989.
Mark P. Kritzman, "What Practitioners Need to Know," Financial
Analysts Journal, January-February 1991.
G.M. Loeb, The Battle for Investment Survival, Barron's Publishing
Company, Inc., Boston, 1952.
Harry Markowitz, "Portfolio Selection," The Journal of Finance, Vol.
VII, No. 1, March 1952.
Harry M. Markowitz, Portfolio Selection: Efficient Diversification
of Investments, John Wiley & Sons, Inc., New York, 1959.
S.L. Mintz, Dana Dakin, and Thomas Willison, Beyond Wall Street:
The Art of Investing, John Wiley & Sons, Inc., New York, 1998.
This book is based on an eight-part PBS documentary hosted by Andrew
Tobias and Jane Bryant Quinn and is thus a fair representation of the
public understanding of modern portfolio theory.
John W. O'Brien, "How market theory can help investors set goals,
select investment managers and appraise investment performance,"
Financial Analysts Journal, July-August 1970.
Thomas K. Philips, "An Opportunistic Approach to Alternative
Investing," Investment Policy, Vol. 1, No. 2, September/October 1997.
Charles R. Schwab, You're Fifty -- Now What? Investing for the Second
Half of Your Life, Crown Business, New York, 2001.
Robert J. Shiller, Irrational Exuberance, Princeton University Press,
Jeremy J. Siegel, Stocks for the Long Run, Richard D. Irwin, Inc.,
Stages, Fidelity Investments magazine for 401k-ers, Spring 2002.
1. Peter L. Bernstein, Capital Ideas, p. 306.
2. A note to professional investors:
This article is clearly not intended to encompass every aspect of
MPT, but to refocus some discussion on the core concepts. This is
necessary, in our view, for two reasons. First, we believe that MPT's core
concepts can't speak to the needs of non-professionals who are making their
own retirement fund decisions (even if we clarify the concepts for them).
Second, we believe that, viewed from the perspective of
commonsense investors risking (in the old sense of the word) their own or
their clients' assets, the foundations of MPT are shaky. We're prepared to be
enlightened, of course, and would welcome comment. We'd insist, however,
that the foundations of any theory need to stand on their own, without
drawing strength from the theory's additional building blocks.
For example, our contention that volatility is not risky would lead us
to argue that neither efficiency nor any measure of risk-adjusted return are
important goals for a portfolio. We would be making that argument in the
context of expected positive stock returns, and one might respond that a
further MPT purpose in controlling portfolio beta is to position the portfolio
for a falling market. That may be true as a description of further MPT
concepts; nonetheless, we would argue that it remains valid to reassess the
core MPT concepts on the same basis as that on which Markowitz made his
original assertions in the 1950s.
For the record, we would also question the value of seeking
efficiency, or of measuring risk-adjusted returns, in a falling market. Asset
owners who are losing money long-term, either absolutely or relative to
other owners, are not likely to be consoled by the ability of their managers
to show that they are losing it efficiently.
3. Peter L. Bernstein, Capital Ideas, p. 41.
4. Thomas K. Phillips, 1997, p. 44.
5. Charles R. Schwab, You're Fifty -- Now What? p. 14 (attributed to Jeremy
6. Mark P. Kritzman, 1991, p. 12.
7. John W. O’Brien, 1970, pp. 91-103.
8. Harry M. Markowitz, 1959, pp. 343-344.
9. Peter L. Bernstein, Capital Ideas, p. 213.
10. Harry M. Markowitz, 1952, p. 77.
11. John Maynard Keynes, 1942, in Classics: An Investor’s Anthology,
12. Gerald Loeb, The Battle for Investment Survival, p. 45.
13. Graham and Dodd, Security Analysis, p. 318.
14. Ibid., p. 320.
15. Jeremy J. Siegel, Stocks for the Long Run, p. 4.
16. Ibid., p. 304.
17. S. L. Mintz, Dana Dakin, and Thomas Willison, Beyond Wall Street,