Portfolio Theory Model: Why are the leading academics not following their own guidelines?

The portfolio theory model (PTM) was developed in 1952 by Markowitz. The idea behind this theory is simple: Investors can reduce risk by diversification and holding a portfolio of investments. If it is so simple, why are leading academics including Markowitz not following this approach? Today in my blog, I will be exploring as to why this is the case.

Portfolio Theory Model

Markowtiz argued that for investors to reduce their unsystematic risk, they would need to hold The diagram uses two parameters: standard deviations and the expected value of the portfolios return. 

 

The envelope curve is represented by the shaded area; investors can construct their portfolio anywhere in this shaded area by holding different combinations of available risky assets.

In order to select the right portfolio, investors risk level need to be taken into consideration as well as identifying the risk free rate of return and capital market line. Taking this into account, maybe adopting the portfolio theory isn’t so simple?

Practical Application

It is can be argued that most people understand the need to diversify; however, the million dollar question is how much?

The proper answer to this question is seen with applying PTM in practice. However, in reality this is not the case.  The vast majority of UK based academics maintain a sensible 60/40 splits between bonds and equities. Leading Academics adopt a similar approach; Markowitz admitted that instead of computing co-variances and drawing up the efficient frontier he split his contributions 50/50. Other examples can be seen with Bill Sharpe and Eugene Fama.  Even those that go that little bit further are only investing into a maximum of 6 funds.

Arnott takes this even further by arguing that most of the advantages of diversifying happen with three or four significant positions in seriously cheap assets.  If you go beyond ten you’re deluding the opportunity set as you are reducing your ability to add value. Tim Bond at BarCap supports this view by saying that in specific circumstances “diversification is the worst solution for your investment needs. Instead you need a narrowly focused portfolio where you are investing in the specific theme.” So why aren’t leading academics following their own advice?

Problems

There are several problems with trying to apply this theory in practice.  One main problem is that the theory is founded on a number of assumptions. Firstly, investors can borrow or lend at the risk free rate; realistically it is highly unlikely that investors can borrow at the risk free rate. Individuals and companies are not risk free thus they will be charged a premium.  Secondly, there are no transaction costs or taxes.  Practically, this is not the case and it can be argued that it is too expensive to construct due these costs. Thirdly, it assumes that utility maximisation is the object of all investors.

Aside from the problems associated with the assumptions made, the biggest question to ask is how easy is it to implement?

PTM is usually implemented using historic returns, standard deviations and correlations to aid decision making about future investments. The model relies on the predictability and stability of the possible profile of returns.  Predicting returns, standard deviations and covariance is a difficult and imprecise art, thus causing potential problems when implementing PTM.  Furthermore, the volume of computations for large portfolios can be inhibiting. 

Could the problems in the theory itself combined with the difficulty in practical implementation be the reasons as to why leading academics are not following their own advice?

Passive Vs. Active

It is clear that the problems mentioned above have significant implications when adopting PTM in practice. However, it should be highlighted that Passive vs. Active management also has an influence on what approach to take.  In fact, it can be argued that those academics, including Markowitz have taken a passive approach. 

Following a passive approach makes asset allocation and diversification easier. It can be argued to be a much simpler and cheaper method of investing as portfolio turnover is much lower thus making it cheaper.  Asset size is not a concern with index funds, and with portfolio turnover being low it explains why those who adopt this method are seen with investing into a total of 6 funds.

Active management involves much more work, and as a result it is argued that portfolio turnover is much higher than the latter thus making this approach more expensive.  However, actively managed funds provide excellent investing opportunities and there are a number of top rated funds which consistently deliver exceptional results. Despite their impressive long-term records, it should be emphasised that these funds can have bad years too. However, overall they best serve the long term interests of fund investors.  PTM can be used as a method of active management.

Conclusion

It is clear that the problems associated with the theory, the difficulty in practical implementation, the different type of investors and the different styles of management need to be taken into account. This can be used to explain why the majority of academics do not follow their own guidelines.  Practical application is a lot more complicated than it appears as other factors come into play.  portfolios consisting of a number of different shares.  As long as the returns of essential assets are not perfectly positively correlated, diversification can reduce risk. Different investors will be willing to take different levels of risk, so how would we choose our portfolio? The theory suggests constructing an efficient frontier of optimal portfolios offering the maximum possible return for a given level of risk.