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Modern Portfolio Theory --- The Root Of All Evil

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Rumor has it that a group of economists were sitting around their super-computers one day, smoking a "pot-pourri" of perfect statistics, when they came to the fairly-easy-to-support conclusion that not too many professional investment managers were able to "beat the market averages" consistently.

With the right statistics (and widely accepted assumptions) this was a simple suit of imperial clothing to weave. And with a ready audience on both Wall Street and Main Street (don't you just hate that expression), this conclusion laid the framework for the passive investment mentality that has overrun the markets.

Armed with some pretty impressive theory, the economists "poipetrated" the very first occupation of Wall Street!

We now have more derivative betting mechanisms masquerading as common stocks than we have common stocks themselves --- 'nuff said on volatility. So long as derivative chips are in play, it (high volatility) will run the casino.

Clearly, the MPT creators were once Mutual Fund investors, looking for something better after years of disappointing investment returns. True, mutual fund managers rarely beat the markets --- but why? And also true, private, individual, portfolio managers rarely fail to beat the market averages over significant time periods.

Mutual Fund managers were destined to failure on the day that the first "self-directed" retirement/savings plan was created. This transfer of management responsibility to inexperienced "main streeters" spelled disaster from the get-go.

At about the same time, market cycle analytics (Peak-to-Peak, Peak-to-Trough, etc) were scrapped in favor of a competitive, calendar year, racetrack scenario.

When the going gets tough, professional Mutual Fund managers become sell-order-takers. When bubbles develop, they are "prospectusly" required to join the lemmings in their race up to and over the cliff. Open-end Mutual Funds are managed by the mob, quite literally.

Independent managers (particularly MCIM practitioners and CEF portfolio managers) have no push-pull relationship with the mob. Management rules are applied to economic realities; probabilities being left to statistical Monday morning QBs. Real managers call the shots, taking our profits before the mob panics and selecting bargains while the cyclical rout is in progress.

The Probability Of Winning The Bet On Probabilities

MPT (Modern, lazy if you will, Portfolio Theory) has other erroneous ideologies and assumptions in its DNA. It wants investors to believe that short term growth in portfolio market value is the be all and end all of investing activity, and that the proper alignment of any number of speculations is an acceptable investment strategy.

The creation, development, and growth of a portfolio's income component is systemically ignored and left to chance in the MPT portfolio design process, while an all consuming battle is waged against the simple fact of a rather simple to deal with reality called the market cycle.

Economists are just naturally averse to admitting that they can neither predict, nor control, nor cope with market, interest rate, and economic cycles as well as a seasoned professional investor just has to. They observe and study the past --- managers, and actual investors, operate in the present, and deal with an unknowable future using rules and disciplines --- not probabilities.

But MPT promoters, university funded economists, and Wall Street have deeper pockets than small and independent investment professionals. The ability to create all manner of securities (and theories) from thin air is clearly more profitable and less risky (from a law suit perspective) than dealing with the intricacies of individual stocks and bonds.

There is no real question about the prospects for market volatility --- it is here to stay. The real question is how to deal with it profitably. The most obvious solution is rapid trading for fun and profit, a conclusion that most readers of this article will nod their heads to.

But long term, portfolio development-wise, looking to a more secure retirement or other objective, there is a non-MPT, non short-term-trading solution --- one that embraces both the extremes of volatility and the repetitive (if not predictable) nature of the market cycle.

Market Cycle Investment Management, with its core equity trading discipline, and mandated "base income" growth mechanisms, is a proven common sense methodology that no self respecting economist will ever appreciate.

The K.I.S.S. principle is just not as sexy as standard deviations, correlation coefficients, alphas, and betas. But basic investment principles, applied with professional decision-making and risk minimization skills, have fared far-better without MPT mumbo-jumbo than they ever will with it.

And, for the record, market volatility is nothing to be afraid of, really --- just bring it on!

Back to: Harnessing Stock Market Volatility 

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