February 15, 2011
Ever since Harry Markowicz published his Nobel prize-winning essay titled "Portfolio Selection" in 1952 in the Journal of Finance, numerous criticisms have been levied against it, even before the onset of the current economic crisis.
Essentially, Markowicz showed, statistically, that diversification among stocks, and, subsequently, among asset classes, results in portfolios with reduced levels of risk at a given return. Conversely, returns can be enhanced at a given level of risk through diversification. Like any other mathematical model, Markowicz's Modern Portfolio Theory (MPT) is dependent on certain assumptions and arbitrary definitions. As an example, MPT arbitrarily assigns a value of one to the beta of the stock market. The question that arises in my mind is why the stock market should be assigned a value of one. The bond market is much larger than the stock market, and the currency market even larger. One would think that one of these two markets would take precedence over the stock market. The fact that neither one has been assigned the magical value of one leads me to believe that the arbitrary assignment of a beta of one to the stock market creates an impression in most investors' minds that this is a must-have asset. It is more psychological than factual. Is it just coincidence that brokerage fees are greater for equities than for bonds? Also, investment in precious metals is discouraged. Is it because brokerage houses don't sell bullion?
There is another question that has been asked before, and it has to do with using standard deviation, or volatility, as a measure of risk. Is this the best we can do? After all, it is well known that the U.S. dollar, often regarded as a paragon of stability - a risk-free asset, as it is often called - has lost over 75% of its value against gold since Nixon took the U.S. off the gold window. Although gold can be volatile, which would you rather own? As a long-term investor, should you be concerned with short-term volatility, or should you be more interested in maintaining and/or increasing the purchasing power of your savings?
In the late eighties and early nineties, there were a couple of studies conducted by Brinson et al that appeared in the Financial Analysts Journal: see references (1) and (2). After studying numerous pension fund portfolios, they concluded that around 90% of a portfolio's variability, over time, can be ascribed to asset class selection, and less than 10% to the selection of individual equities. This is a startling fact. If 90% of the variability can be ascribed to asset class selection, shouldn't you be conducting due diligence on the various asset classes available to you for investment, and spending less time and effort on individual stock selection? Given the nature of the times, and the fragility of paper currencies, shouldn't you have the majority of your savings in tangible assets like gold and silver, and far less in assets that are based on fiat currencies? And, should you even be measuring the value of your stocks and bonds in terms of fiat currencies? Shouldn't you measure them in terms of ounces of gold and silver? These studies must be revealing, especially, to those of you who spend endless hours researching stocks.
Once you realize the importance of Brinson's studies, which are based not on a theoretical construct, but rather on substantive and substantial data, you really need to ask yourself, "What types of assets do I want to own in an era that can only be defined as the race to the bottom in the context of fiat currencies?" And lest you think that real estate is a hard asset, I would point out that it is now part of the credit bubble, and will only return to its true nature of being a hard asset after an exhaustive liquidation.
Mark Lundeen did an exhaustive paper - that showed how little the Dow Jones Industrial Average depended on earnings, and how much it depended on the Federal Reserve for support. Well, credit creation will take you only so far. When debt monetization is added to the mix, the results can be disastrous. Do you know when the tide will turn against you?
So, before you go venturing out into the investment world, be cognizant of three things:
- that 90% of a portfolio's variability arises from proper asset selection
- that entire classes of financial assets that may exist in your present portfolios should be regarded as derivatives of endless currency creation and
- remember John Exter's inverted gold pyramid. (If you google "John Exter's Inverted Pyramid" you'll find numerous references to it
In my opinion, precious metals are the go-to asset class for today's investor. Paper asset pushers may regard gold and silver as speculative; gold bugs may regard them as wealth protection; in reality, they could be your salvation.
References:(1) Brinson, Hood and Beebower, Financial Analysts Journal, July/August, 1986
(2) Brinson, Singer and Beebower, Financial Analysts Journal, May/June, 1991
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