Were Eggs In Different Baskets Cracked During The Financial Crisis?

In 1952, Harry Markowitz developed his Modern Portfolio Theory.  This theory was based on the concept of investors not placing their ‘eggs all in one basket.’   The central idea to this theory lies in the fact that the market risk resulting from holding a financial instrument can be reduced by incorporating this instrument into a portfolio of instruments (Vaclavik and Jablonski, 2011).  In other words, investors are able to reduce risk by spreading investment across a range of investments so that if one investment performs poorly, this would be compensated by another asset performing better.

Even though Markowitz was awarded the Nobel Prize for his Modern Portfolio and has been referred to by investors for over 60 years as they seek to maximise their portfolio return for a given amount of risk, it has come under intense criticism and scrutiny over several years, particularly in the aftermath of the financial crisis.

Some high profile personalities have questioned Markowitz’s Portfolio Theory with arguably one of the most famous and successful investors Warren Buffett describing it as a ‘low-hazard, low return’ and therefore was dismissal of the idea.  He even went on to say that ‘wide diversification is only required when investors do not understand what they are doing’ (Bang and Sakaldeepi, 2013).

While Warren Buffett did not look in particular to the financial crisis to support his opinion on the Modern Portfolio Theory, an article in the online newspaper, ‘Pensions and Investments’ has argued that the flaws in the theory were evident during the financial crisis.  The article stated that the two assumptions of constant volatility and correlation were flawed because the financial crisis meant that there was ‘volatility in correlation i.e. the correlation itself was not stable and there was ‘volatility of volatility’ i.e. volatility becomes unstable when asset returns are going down.  The writer of this article referred to these two assumptions as ‘the evil twins (Haworth, 2012).  Another critic who has looked to financial crises to prove flaws in the Modern Portfolio Theory is Yves Bolton, the wealth management chief investment officer at Pictet & Cie, the Swiss private bank. Bolton looked at the historical relationship between the S&P 500 and the US Treasury.  The aspect of the Modern Portfolio Theory which he criticised in particular was the assumption of the Modern Portfolio Theory that bond and equity prices were positively correlated, stating that that the relationship was negative as a result of the Asian Financial Crisis in 1998 (Foster, 2010).

Some evidence which may suggest that the Modern Portfolio Theory is flawed is the fact that hedge funds have underperformed in recent years.  Hedge funds have generally underperformed equity markets and last year delivered their overall worst performance in the USA since 2011, gaining just 3.8%.  This is because markets have tended to move in the same direction and therefore there has been less of a need for investors to protect themselves against risk by diversifying their investments (Pett, 2015).  However, as mentioned in my 2nd blog post on stock market efficiency, it has been noted that investors have been switching from active to passively managed funds which suggests that investors are now reverting back to the Modern Portfolio Theory.

I support the Modern Portfolio Theory because it seems the most rational approach to take for investors in order to maximise return for a given amount of portfolio risk.  I think that the Modern Portfolio Theory has been used as a ‘scapegoat’ by critics who are trying to find easy targets which they believe may have contributed to the Financial Crisis.  Obviously, financial crises are going to raise questions about the validity of the theory, however the Nobel Prize winning theory should not be completely disregarded because some people were at the wrong end of it in 2007/2008.  I think that they should be reviewing issues of more significance which were highly evident during the Financial Crisis such as poor Corporate Governance, the importance of which I highlighted in Blog 1.

Bang, N., & Sakaldeepi, K. (2013). Concentration: the case for putting all your eggs in one basket. Retrieved 7th March 2015 from http://www.ft.com/cms/s/0/d4e511fc-250f-11e3-bcf7-00144feab7de.html#axzz3TWfzteey

Foster, J. (2010). Back to the Drawing Board. WSJ. Retrieved 7 March 2015, from http://www.wsj.com/articles/SB10001424052702303960604575158141978114692

Hawworth, R (2012).  2008 revealed flaws in modern portfolio theory.  Retrieved from 06^th March 2015 from http://www.pionline.com/article/20120920/ONLINE/120929999/2008-revealed-flaws-in-modern-portfolio-theory

Pett, D. (2015). Hedge fund returns poised to catch up. Financial Post. Retrieved 6 March 2015, from http://business.financialpost.com/2015/02/18/hedge-fund-returns-poised-to-catch-up/

Vaclavik, M., & Jablonsky, J. (2011). Revisions of modern portfolio theory optimization model. Central European Journal Of Operations Research, 20(3), 473-483. doi:10.1007/s10100-011-0227-2