The Poison of 1974

Cars have changed a lot since 1974, as this advertisement for the 1974 Ford Mustang II illustrates. Regardless of whether cars have come as far as they should have over the past thirty-five years, the fact remains that what was then thought to be modern and forward-thinking in an automobile looks pretty out-of-date today.

However, when it comes to money management, an idea that was thought of as modern and forward-thinking in 1974 continues to grip much of the industry. "Modern portfolio theory," so-called, is a set of mathematical concepts developed by academicians in the 1950s and 1960s that purported to determine the ideal portfolio for any level of desired risk (and purported to be able to mathematically define risk precisely enough to be able to accomplish portfolio optimization at various desired risk levels).

As we have explained previously, this academic theory began to infect professional money management in 1974 as a reaction to the severe bear market of 1973-1974. See "Beware of the witch doctors of modern finance" for that discussion, along with quotations from influential voices such as Peter L. Bernstein and Paul A. Samuelson who declared the dawn of "the new world of the academics with their mathematical stochastic processes" over the old world of money managers with investment methods derived from practical experience in the stock and bond markets.

We have always believed that this infection of the financial world with "modern portfolio theory" was a relic of the 1970s that should have been scrapped along with many other dubious ideas of that decade that have since been repudiated.

As we have explained in many previous posts, such as this one and this one, investment is ultimately about matching capital with innovation, and innovation is something that mathematical models cannot predict.

We have also pointed out that the global financial crisis of the past eighteen months should have exploded the foundational assumption of Modern Portfolio Theory that risk can be mathematically modeled and diversified away using portfolio optimization techniques that turn out to be dependent upon speculative calls about the direction of commodities and currencies.

The most recent bear market should serve as the wake-up call that ends the thirty-five year sleeper hold that the theories of 1974 put on the financial services industry. Unfortunately, the current financial industry is so built upon the tenets of Modern Portfolio Theory that it can accurately be described as a product of Modern Portfolio Theory, as we have explained in many previous discussions of the "intermediary trap."

It is clear that a huge number of investors today have correctly concluded that there is something wrong with the current set-up, but they don't know exactly what it is. Numerous articles are appearing in financial journals, such as this recent WSJ article, documenting the dissatisfaction with the state of affairs on Wall Street, without understanding the underlying cause of the problem.

In fact, a few months ago we linked to an article by the same journalists which interviewed a variety of disgruntled investors who were trying to change their strategies after the bear market, and yet the irony of the story is that the investors are fleeing to "structured products," "managed futures," "hedge-fund-like mutual funds," and "trading systems" based on "computer models." In other words, outgrowths of the same old Modern Portfolio Theory that took root in the 1970s, albeit dressed up in newer terminology.

The effects of the infection of 1974 are potent and deeply rooted. We would recommend that all investors, as well as journalists who are writing about the current state of investing, examine this issue and take the time to understand it. Unless, of course, they drive a 1974 Mustang II.

For later posts on this same subject, see also:

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