Modern Portfolio Theory (MPT) is past its sell by date because it was based on fundamentally flawed logic.

MPT is based on the theory that volatility = risk.

The fundamental flaw was mistaking correlation for causation. The correlation observation was that:

Equities are more risky than Cash (True)

And,

Equities are more volatile than Cash (True)

Therefore,

Equities Volatility causes Risk (Untrue)

That is flawed reasoning. Volatility does not cause risk. Volatility is a sign that Mr. Market is schizophrenic; sometimes he is Mr. Bear and sometimes he is Mr. Bull. Mr. James Pierpoint Morgan when asked what the stock market would do famously remarked,

“It will fluctuate”.

The result of that flawed logic has been decades of MPT based investment programs that share a common objective to reduce Volatility. That was the wrong objective. The objective should be to reduce risk, not to reduce volatility.

Investors only need to worry about volatility if they are forced sellers because they need the cash. If you have conviction in a stock, a fall in the price is a reason to buy more (as long as you have the Cash to do this).

The defenders of the MPT orthodoxy point out that:

1. Equities are more risky than Cash. Therefore getting your allocation of Equities vs Cash is still the smart thing to do. Yes, having the right allocation to Cash is important. First you need enough cash for your spending needs, so that you don’t have to sell a great stock just at the point when it has crashed. Second you need what some call “dry powder” and others call “optionality” which means the cash on hand to buy when prices crash and your high conviction stocks are cheap.

2. Bonds are a Cash substitute. This is a mistake.There are some short-term, self-liquidating credit instruments and these are more cash-like and there are short-term Treasury Bonds that you can treat like Cash (i.e. you won’t earn much money on a 3 month note but you can cash it in by just waiting till maturity so that you can buy that higher yielding opportunity). However the majority of Bonds do not equal cash. Bond prices go up and down based on interest rates and credit risk. If you loan money to the US Government for 10 years and at the time when you need the cash the politicians are fighting about the debt ceiling, you will be faced with the same dilemma as an Equity investor with money in a great company where the stock has just tanked.  If you treat Equities as profit generating machines, their properties are similar to Bonds; they are both cash flow machines. However the risk is driven by the fundamentals in both Bonds and Equities, such as changes in the revenue and cost structure (of countries as well as companies).

Smart investors have always known these facts. That is why sophisticated investors use structures such as Preferred Stock that to reduce their cash flow risk while exposing themselves to the Equity upside. Is Preferred Stock a Bond or an Equity instrument? To a sophisticated investor it does not make much difference. In short, “It’s the Company, Stupid”. Look carefully at the fundamentals of a company and then the transaction instrument is a relatively simple secondary decision.

Betterment and Wealthfront are great ventures run by hugely talented and driven entrepreneurs. They are doing well by most accounts. They are offering portfolio allocation (getting the right mix of bonds vs cash) using automated tools,  so they can offer low cost alternative to the old way of doing asset allocation. That is a lot better than the expensive asset allocation diversification that one wealthy investor (Mark Cuban) skewers in this post. However as any developer knows, a coding error is cheap to fix but a specification or design error is expensive. Modern Portfolio Theory is wrong because the fundamental logic (that volatility causes risk) is flawed.

So, what is your average Jane/Joe to do? The other fundamental assumption behind all of Wall Street and all automated asset allocation tools is that retail investors cannot invest well in stocks. Mark Cuban agrees with Wall Street on this question. In this video with WSJ, Cuban says that it might have been OK for Warren Buffet but others cannot replicate that but he also offers one great bit of advice:

“Unless you know something specific, put it in cash”.

That something specific is the Alpha that Hedge Funds offer for the price of 2 and 20. It is an insight about a company or a market based on work that you have done. (Note, this is totally different from “I got a stock tip from a mate or from the media” or “the latest IPO is all over the media and sounds really exciting”. This is more along the lines of “I can see from my work that x is definitely true/untrue and the consensus does not see this yet” (and yes there is a fine line around insider trading that needs to be carefully navigated).

My theory is that:

“All of us have latent Alpha”.

We just have not had the tools to do something about it. That is changing, thanks to XBRL:

XBRL democratizes fundamental stock analysis in the same way that PCs democratized computing and social media democratized HTML. 

The tools that consume XBRL and enable Joe Latent Alpha to do something with his insights are still at an early stage but they will have a big impact when they get to prime time. In the meantime, we will see if Wealthfront or Betterment make it to IPO (giving them a huge mindshare boost). If one of them makes it to IPO, the data will become visible and then your average Jane/Joe will be able to compare their financial metrics to traditional asset allocation firms and make a decision whether they are a good investment.