The Failure of Modern Portfolio Theory

Modern Portfolio Theory, as brought to you by the Pulitzer Prize winning Harry Markowitz, was originally published in 1952.  With later additions by Merton Miller and William Sharpe, its technical market analysis and risk adjusted return theories remain just that, theory, not fact.

The theory is followed, to one degree or another, by most investment professionals.

According to the theory, investors are risk adverse: they are willing to accept more risk (volatility) for higher payoffs and will accept lower returns for a less volatile investment. The theory is simple and elegant, and can lead further into various mathematical proofs and equations, which probably has a lot to do with why it has become so widely accepted.

If you have checked your returns lately, the risk adjusted return your portfolio incurred based on these theories has left you, should we say, wanting.

In this writer’s opinion and experience, cash flow is the driving force in any asset classes’ success or failure. Just watch the markets for one week, and see how the tide turns from one asset class to another based on yields vs. profits (or perceived future profits).

So let’s skip the major formulaic crap and cut to the chase. No, in fact, let’s give up the chase. Chasing perceived multiples, chasing past performance, trusting our corporate institutions to grow larger and larger profits (at any cost), and turn to the truth of what really drives the value of a given asset.

And really, what is it that you, the everyday investor are looking for in your portfolio? We’ll get to more on that later.

Let’s say I own a company that makes widget “A”. I sell these things like crazy! However, my profits are low due to poor pricing, paying too much for supplies, labor, cost overruns, etc.;  generally bad management. Of course all of these data points are going to show up in my public reports. But what is the real tale? My company has poor cash flow. The beta, Sharpe ratio, r-squared, sector, or industry while all indicators, confuse the long term issue. My company’s cash flow sucks!

Compare that with the company with widget “B” with similar sales, but better management. This also company sends you a check every now and then; from 1 to 12 times a year, because of positive cash flow, I the investor get a piece of this company’s action.

Both companies are now for sale. Which one would you pay more for? If both companies have similar outstanding debt, in that moment of purchase, a rational person would buy company B.

Did you need formulas, risk tolerance tests, or some version of portfolio selection to make that decision? Perhaps these are helpful guidelines in developing an overall portfolio, but not in that buying decision of that specific capital asset.

Now, let’s leave the world of Wall Street for a moment and turn to Main Street (such an overused cliché, let’s use your neighborhood instead). In your neighborhood, there are 2 rental homes for sale. On one block a home has a renter paying $500 month in rent. On another, the renter pays $550 per month. Both homes are otherwise identical. To receive a 6% rate of return (Cap Rate) on either house, I would have to pay more for the house that produces the bigger monthly check, i.e. the one with more cash flow holds more value.

And so it goes, with each asset class we examine. Bonds with higher yields than the current market offers sell at a premium. Commodity prices are priced based on demand, or perceived demand, which translates into how much cash flow is in the economy to allow people to want more of that “thing”.

It goes on and on, but it all boils down to the main ingredient in financial success. The “show me the money” rant, so to speak.  Cash Flow.

Now, let’s visit what it is that you are looking for to achieve financial success. Is it a large net worth? They even have advertisements showing people carrying around their “number”. I believe using “modern” or even post-modern portfolio theory is only a small part of selecting your portfolio’s asset choices.

A safer, common sense, simpler, and more systematic approach is to look to grow your cash flow, every year, and then your net worth will take care of itself. In fact it won’t even matter.

The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective. - Warren Buffett

About Roger Simard

Roger P. Simard, CFP® Roger P. Simard is the founding principal of Genesis Financial Advisors, LLC, and Genesis Tax Advisors, LLC. He heads the firm's corporate and personal financial planning practice and oversees all operations. Mr. Simard concentrates his work in the fields of financial planning, real estate investing, tax planning, and portfolio management. Mr. Simard is a Certified Financial Planner™ and has over 23 years of experience helping individuals and businesses achieve financial success. Mr. Simard was a speaker for The Prudential Spirit of Community Awards, a nationwide youth recognition program honoring secondary school students for outstanding service. He is a frequent speaker and radio guest on business and taxation issues and successful investment strategies and provides Continuing Education classes for Realtors.
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One Response to The Failure of Modern Portfolio Theory

  1. Dave Green says:

    I really enjoyed reading your blog and appreciate the sound advice and agree with your comments regarding growing your cash flow. I will look forward to reading you future blogs. Thank you for this excellent addition to your website and I shall encourage my friends to visit also.

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