Modern Portfolio Theory and Chill: Don’t Panic When The Market Drops.

Modern Portfolio Theory and Chill: Don’t Panic When The Market Drops.

Everyone else is panicking. But you are not. You are quite calm. 

They are selling their assets for a loss and hoping to predict a bottom to get back in. But you are not thinking about selling. You are actually investing just like you always do, knowing that stocks on sale are a bargain. 

 

 

Suddenly, everyone is struggling to find “safe havens” for their money to ride out the dip. You are not.

You’ve already invested in safe havens for years are appreciating the gains in those assets as people jump in and pay a premium. 

 

Pundits and friends, who for years told you that they can accept a high-risk asset mix are now painfully feeling every drop in the S&P. You aren’t even following the market.

It’s been said by Warren Buffet that, “When the tide goes out, everyone can see who’s been swimming naked.” They are fighting desperately for some cover. Not you, you are happy with your risk level and have a nice cozy cabana on the beach with an excellent view and a cool tropical breeze. 

You can just Modern Portfolio Theory and Chill. 

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The secret of Modern Portfolio Theory 

Harry Markowitz had a choice to make early in his career. Flush with cash from a new job, he wanted to invest. However, he didn’t know whether to invest in stocks or bonds. There was just no way for Markowitz to know which would do better. He was no slouch either, with an advanced degree in economics he knew all about investing and predicting future markets. But he was also honest with himself and realized that no can predict the future. So, he invested in both. Sounds simple, right? But the idea was revolutionary at the time. How revolutionary? Markowitz won a Nobel Prize for the idea in 1990.  

 

Investing is like a highway… 

Ok, maybe it is like a highway. Maybe it’s not. But it’s a great model to help explain Modern Portfolio Theory in a way that is useful, if not perfect. 

 

Note: I’m going to use highway travel as a model to explain Modern Portfiolio Theory.  Some readers have  noted that it may get a little confusing at first, since the model has some odd rules and it’s easy to wonder where I’m going with all of this. This “highway model” is what I use to teach 12-15 year olds about MPT, so I find it very effective. Please try to stick with it, I’ll wrap it all up and hope it will make sense in the end. Keep in mind that each “lane” in the highway is an asset class- the left left could be stocks, the middle bonds, the right lane real estate, etc. You don’t need  to focus on the exact asset class. The idea is the you want to arrive at your destination in the quickest way possible, but also do so safely. With that in mind, Let’s dive in-

Let’s imagine you are planning to drive from Boston to Miami on I-95.

  • For purposes of this model, assume there are three lanes the whole way down.
  • Also, imagine you get to choose which lane you want to travel in from Boston to Miami. You also must choose your lane before you start your journey.
  • If you were to decide to change lanes while traveling, you’d need to sell your already purchased miles and buy new ones, likely at a premium and a transaction fee. So you really don’t want to change lanes.
  • The whole highway is a toll road. You pay a certain fee per mile for the privilege of using the highway.
  • You have information from previous trips, but no real way to know what the travel will be like when you actually get on the road. You also must choose your lane before you start your journey.

Now, anyone with experience will choose the far-left lane. That’s supposed to be the fastest. But, is it always the fastest? Since everyone knows it’s the fastest, they all pile in and it slows down. Or, everyone gets excited, they go too fast and there’s wreck. Sometimes, the highway department gets lax, and then they have to close it down to fix the mess they created.

The same can be said for the middle. It’s usually pretty good, but it’s not the fastest. Yes, you’ll get there, but it will be frustrating when the cars to the left zoom by. But, extremely reassuring when the left lane is sitting still and you drive by.
 

The slow lane on the right seems like a terrible choice. But give it a second thought. Its slow and steady. Easy to get off and hit the rest stop or Popeye’s and get back on. It’s really hard to do that from the far left lane.  There are rarely accidents in the right lane, so although it may be slower, there is a consolation in knowing that you’ll have a high likelihood of arriving at your destination safely. And, when you get close to Miami, you want to move over and slow down to be sure you arrive in a safe and steady manner even if takes a little more time.

Now that you know your choices. Pick a Lane.

 

Which lane do you choose?  

When forced to choose only one lane on your trip from Boston to Miami, you are forced to make a prediction. One that you will get exactly right by pure chance. Maybe the Left Lane will get you there fastest. But there could be a horrible overturned truck in New Jersey that keeps you there for 16 hours. (Remember, in this game we are using an odd model where you choose a single lane and on stuck there.) Also, everyone would choose the left lane. Some wise people may choose the middle knowing the left will be crowded. Maybe the Right lane will be empty the whole way…

In many ways, this is the problem that Markowitz faced early in his career. By having to choose only one option or asset class (IE; stocks or bonds) he realized that he had no way to predict the future and make the exact best choice. Sure, he has some theories and historical data, but none of this could give the exact best choice every time. Markowitz solved this problem and so can you.

 

 

Imagine you could choose all three lanes. 

When the left lane is closed, you jump to the middle or far right lane. Smooth Sailing!

Buying all the lanes at once is a great idea, but there’s a problem. Anyone who travels toll roads knows that you get charged per mile. So, you’d be charged the full price for each mile of each lane. Yes, you’d get there in the fastest possible time. Unfortunately, there would be a cost for buying all lanes even when you are not driving on them. To pay for that extra cost, you’d need to work more hours to earn the money to pay the tolls. That extra time working needs to be added to the time it takes to make your trip. Time, like money, is fungible- it doesn’t matter where and how you “spend” it. It all needs to be taken into account. 

What you really need is a way to efficiently purchase miles on each of the three lanes to get you to Miami at the highest speed and at the lowest cost. 

 

 

The Efficient Frontier 

You are no fool. Every time you drive you keep track of what lanes are the fastest. You even found a website that has this data for the past 20 years. Sure, the fastest lanes fluctuate over time, but there are some clear trends. You even think you can understand what is happening some of the time, like at night, during rush hour, or when it snows. Even though, you can see some trends, it doesn’t really help in the long run and often the traffic just doesn’t follow the pattern you predict. You realize that if you could actually predict the trends with accuracy, you’d be loaded. There are little ads on the websites of people who claim they can, but you wonder about their about their integrity and honesty.

After study, you learn that the left lane is fastest 50% of the time. The middle lane is fastest 20% of the time and the right lane is fastest 15% of the time. You also learn something else that was unexpected. The train-car line (where you park on the train and ride in the passenger cabin) is fastest 10% of the time. Most surprising of all is the back roads. Usually they are much slower, but 5% of the time they actually move faster like when there is a big truck accident or a bridge collapse and the highway is at a standstill.

So how do you proceed? You come up with a plan. You buy 50% left lane miles, 20% middle lane miles, 15% right lane miles, 10 % Train-car miles and you even sprinkle 5% of your budget on the back roads. You have split up your miles based on what your research has shown to be the most likely to be the most effective use of miles. The one that is most likely to get you there in the fastest time, with the ability to change lanes when something goes wrong, and the one that is most likely to get you there safely. Sure, it may take more time than amazingly lucky roll of the dice on just the left lane only, but you’re also less likely to lose it all in an accident or highway failure. You’ve invested your miles along an “efficient frontier”

 

 

By “investing” in miles and diversifying your mile purchases you’ve accomplished several goals.
 Think about how your plan affects your travel outcome  

  • You’ve bought the most miles in the fasted and the least in the slowest, thereby making the best use of your mileage budget 
  • When the Left lane closes, you don’t panic. You have the other lanes available and working for you 
  • When the entire highway is closed for any reason, you have some alternatives available. You can hop on the train or take the back-roads.
    • You don’t need to seek “safe havens”. You’ve already bought those miles. Now your fellow travelers have to buy those miles from you at a premium
  • You also realize that sometimes thing happen affecting all travel that you have no control over. A hurricane may hit. There can be a blizzard. Sometimes these events are man-made like when a city overbuilds due to poor planning and the electrical grid fails throwing everything into chaos. But you don’t panic.
    • You even start to buy miles for a lower price from your fellow travelers who panic and decide to walk.
  • You know that as soon as anything starts to move, you’re are positioned to take advantage of it. You’re not going to abandon your car and try to walk. 

 

Modern Portfolio Theory 

Of course, this model is a primitive attempt to describe long term investing. You can replace the left lane with stocks, the middle with bonds, and the right with real estate, the train-car wuth cash products like CD’s and the back-roads with gold or whatever and you get the idea.

If you diversify your asset class, you’ll be well positioned to ride out the hard times and prosper in the good ones.  Since, you already own multiple assets classes, you don’t need to sell and move your money or “flee” to safety. There’s even a good chance the one of your asset classes is doing better while the others are under-performing. Finally, you’ve chosen the percentage of your asset distribution based on experience and risk tolerance. So, you don’t need to panic.

You can just Modern Portfolio Theory and Chill.

 

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So what do you think? Personally, I really enjoy being able to keep my head while everyone around me is losing theirs. I’m keep telling them to “MPT and Chill”, but they insist that the sky is falling and they need to sell everything at a loss…  Leave your thoughts in the comments.

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