Modern Portfolio Theory Is Broken

Video Transcript: Modern Portfolio Theory is Broken

I’m going to talk a little bit about–kind of the common knowledge or the common belief–about something called modern portfolio theory.  It’s very well known.  It’s kind of the best way–the best known way–to manage a portfolio in order to be diversified.  You know it’s based on not putting all your eggs in one basket and when you’re looking to diversify a portfolio many use the modern portfolio theory. 

Ray Dalio is known for this for using this concept and it can be very useful.  It’s been referred to as the holy grail and the concept in a nutshell, mathematically creates lower risk just by adding non-correlated assets into a portfolio.  So for example–and I’ll just be making some of these numbers up just to make the point.  If you have a portfolio with three assets, let’s say you pick SPY (which is the S&P500), TLT (which would be bonds), and GLD (gold) your goal in picking the three assets would be to pick the three that have the least amount of correlation.  So if I pick those three, those may or may not be the best uncorrelated assets, but I’m going to use them just as an example. So you don’t want them to move together.  If those three assets are in your portfolio you don’t want them to move together, or when one moves lower the other might stay the same or even go higher.  So let’s say based on the average year–again these are numbers I’m just making up–the SPY draws down 15 percent and TLT draws down 10 percent and GLD draws down 20 and this is all happening within about an average time span of a year and this is what you have in your portfolio. 

If you held these three assets you would expect an average drawdown of 15% plus 10% plus 20% which equals 45% and you divide that by three.  So you would expect an average drawdown of around 15%.  But using Modern Portfolio Theory you can do a calculation and based on how uncorrelated the assets are–or the less correlated the better of course–the total combined assets will actually draw down less than 15%.  For example you would expect a three assets portfolio to draw down 15% in a year, but when all three of those are combined into one portfolio the drawdown (because they’re not correlated) is lower like maybe only 10%. 

So Modern Portfolio Theory dictates that combining uncorrelated assets decreases portfolio volatility which decreases drawdowns while maintaining the same amount of returns.  Thus creating better risk adjusted returns compared to holding the assets on an individual basis.  Now there is a point of maximum efficiency and this level can be graphed and it is called the efficient frontier.  Now I’ve had several conversations with very smart people about this Modern Portfolio Theory and I personally do not like to have a long portfolio because I don’t believe the Modern Portfolio Theory actually holds its weight. I just want to be clear.  It’s not that it doesn’t hold its weight and that the theory itself doesn’t work, it’s the way that the theory is applied by almost every money manager.  Now there is one kryptonite to Modern Portfolio Theory.  One thing that can attack all portfolios, even those maximized by the Modern Portfolio Theory efficient frontier. 

The kryptonite occurs in the new market environment we find ourselves in.  Recent events that occurred in August of 2015, February 2018, and March 2020 are events that have not been seen since 1987.  In my opinion now these modern events are a recent change in the market.  And what am I talking about?  I’m talking about the modern crashes that occurred in the market and these recent crashes have turned the way that the Modern Portfolio Theory is applied on its head.  Modern Portfolio Theory relies on uncorrelated assets to maintain stability in the portfolio but during these modern crashes all assets became correlated. 

Now why did that happen?  Well the answer is leverage and algorithms.  There’s so much leverage in the system that a small downturn can force deleveraging and everyone wants to be first to get out.  So the algorithms trigger panic selling.  This panic selling causes a crash and a large volatility spike.  This type of modern crash causes margin calls and forces one set of assets to be sold to cover the other set of assets.  This means no normal asset is safe in a crash.  And in my book that I wrote in 2019 called a portfolio for all markets I call this crash correlation. When all normal assets are selling off and become correlated the Modern Portfolio Theory breaks down because it relies on one asset to be uncorrelated; because it relies on assets to not be correlated and thus protect each other; but all assets in a crash are falling and this is why a crash combined with leverage causes excess losses even with portfolios that are supposedly uncorrelated. 

The key to diversification is not using Modern Portfolio Theory like everyone else by attempting to un-correlate the normal mix of assets.  The key is being long an asset that significantly increases in value during a crash when all the other assets become correlated.  The asset I’m referring to is volatility.  If an asset manager is long volatility then they will not be forced to liquidate in a crash because volatility becomes the only asset increasing in value in their portfolio.  Volatility is not only uncorrelated with other assets during a crash it actually significantly increases in value.  The key to diversification is being long volatility.  Now being long volatility is nothing new.  The problem with being long volatility is the cost.  Every long volatility hedge has a cost to maintain it.  If you’re adding a long volatility component to your portfolio then it’s costing you money every year, and it can become difficult to justify that cost because crashes may only occur maybe once every three to five years; and it’s hard to justify a significant drag in the portfolio over a few years without any return on that investment.  In order to compensate or take advantage of volatility, I use a trade structure that makes money and contains a long volatility component.  And this is the reason I put my own money into this trade and I’m not worried about a market crash. 

Now the trade I’m referring to is the Five Step Options Trading Success Program.  Now this program trades with black and white rules and this system is available to you.  Just see the link in the description below.


5 Step Options Trading Success Program:

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