Modern Portfolio Theory is Dead…?

At a recent luncheon, I watched the Chief Investment Officer of Northern Trust make arguments that seem all too common this year.

His main point was that using Modern Portfolio Theory (MPT) is “the old way of doing things” because in 2008, assets that should have zig-zagged independently all dropped last year.  The implication, of course, is that diversification failed when it was needed most, and that asset allocation doesn’t work. 

I find this to be a typical gimmick to lure people (new customers) who got slaughtered by investment markets last year and are searching for better ways to invest their money.  But allow me to pick apart their main arguments:

Their Point: Correlations are not stable and go to one (1) during a crisis; so regardless of whether you have real estate, international stocks, or small cap stocks, it will not do you any good. 

My Counterpoint: Many studies show that this conclusion is not true.  Work by Loretan & English as well as Kim & Finger and Ragea show that higher correlations are simply a result of higher volatility, not because of some “contagion” spreading across equity investments; that correlations apparently increase, but don’t actually change.

If they really believed this claim, their portfolios would only include two assets, the market index (S&P 500) and US treasury bills; however, their sample portfolio included allocations to real estate and hedge funds.

Their Point:  You should create a cash flow immunized portfolio to minimize the potential shortfall.  In other words, treat your portfolio like a pension fund.

My Counterpoint:  This strategy may be useful in many situations, but equally inappropriate in just as many others.  If you knew with a high degree of confidence that the objectives, timing, and risk tolerance would not change over time, or with changes in market conditions, then you have a much better case with the immunization strategy.  The reality is that life happens, goals shift, tax laws change, and among other things, people change.

Their Point:  Diversificaton failed, MPT is dead. 

My Counterpoint:  Modern Portfolio Theory has long been abused by many practitioners; particularly by those who rely on mean-variance optimization software – as if mean returns and variance are the only important factors?!  What does it say on all investment literature? Past performance is no indication or guarantee of future performance.  Yet, many practitioners plug in historical return information into their software to finalize an asset allocation model:  Garbage in, Garbage out.

In the end it’s just a theory; so what happens in practice?  When the father of MPT, Harry Markowitz, was asked how he would invest among stocks and bonds, instead of making intricate calculations, he replied, “My intention was to minimize my future regret… So I split my contributions 50/50 between bonds and equities.” 

Markowitz chose to minimize his regret instead of minimizing portfolio variance!

Going, going, gone are the old 1980 Mortality tables

As many of you are probably aware, states are adopting the new 2001 CSO (mortality) table which has had life insurance companies busy redesigning their products. Basically the new table reflects the fact that people are living longer these days than they were compared to the old 1980 table. Now that people are living longer, life insurance should be cheaper!

I’ve seen that quotes for insurance have come down but not in a ‘wholesale’ type of fashion. Generally the change will only have a small impact on the average consumer, and I would be wary of anyone that told me I should replace my existing (life insurance) coverage because this new table is being adopted. There are other factors that should be considered irrespective of the table.

However, if you are in a situation where a cash value life insurance product (e.g. VUL) makes sense, you will want to be sure to evaluate your options before insurance companies stop selling 80CSO (old) insurance products December 31, 2008. This is because the definition of life insurance cost and modified endowment contract definitions are based on the prevailing table (soon to be 2001CSO).

Basically if you want to pump a lot of money into one of these policies (overfund), you should look into the old contracts while you still can. Again, I would be very wary of information you come across on this; remember, most life insurance is “sold” not bought by people.

Finally, consider that insurance companies and brokers are always trying to squeeze out as much profit/commissions as they can from the (life insurance, and other) products they sell. As the transition to the new table concludes, companies may over/under price their new insurance products – so be sure to shop around!

FICO Scores are changing soon

Fair Isaac & Co. is tweaking their methodology for computing an individuals FICO score in 2008. As you may already know, your score affects the rate you pay on loans (mortgages, auto, credit card); but you may not know that your FICO score is now frequently used by auto insurance companies, employers, hospitals, and others.

It’s more important than ever to ensure you have the highest FICO (credit) score possible. The typical recommendations for improving your score are:

• Avoid using too much of your available credit card debt
• Remove errors on your credit report (get reports free at www.annualcreditreport.com)
• Avoid making late payments
• Shop for auto/mortgage loans all during the same month
• Maintain old credit card accounts and if necessary, use them on occasion to keep them open

However, there are additional recommendations given what we know about the new scoring methodology:

• If you’re an authorized user on someone else’s credit card, you need to drop that and get your own card. FICO will no longer count authorized users toward good credit.
• Try to have a mix of loan types on record. You should have a better score if you have installment loans (student, auto, mortgage) and revolving accounts like credit cards.
• Pay your bills on time! More weight is being placed on billing issues (delinquencies) compared to the old FICO calculation method.

There are of course other credit rating systems out there, but these systems (including FICO) are all black box calculations that look at similar factors. Most of this work to repair or protect your credit is pretty straightforward, and if you maintain good habits around debt you’ll be in good shape. For those with problems, you will have to be patient since improvements take a while to “stick”; don’t be tempted by quick fixes or credit repair firms!