Modern Portfolio Theory’s Biggest Flaw

Modern Portfolio Theory (MPT) had one major flaw from the beginning.  The assumption that there is such a thing as a “risk-free” asset.  It is the same flaw that exists for most portfolios today.

Before I get into the flaw, a little background on MPT

In a nutshell, MPT attempts to create an optimal portfolio by identifying a client’s risk tolerance.  To do so, would take care of the “two kinds of risk” that are prevalent (according to MPT) that are prevalent; Systematic Risk (like recessions and wars) that cannot be diversified away and Unsystematic Risk that can be diversified away with more share ownership.

To invest with the appropriate amount of diversification and risk tolerance will lead the investor to  “efficient” portfolio.  To optimize this efficient portfolio,the Sharpe ratio is analyzed which reveals the amount of additional return above the “risk-free” rate a portfolio provides compared to the risk it caries.  The portfolio that has the highest Sharpe Ratio is known as the market portfolio.1,2

A “risk-free” asset in this case, according to MPT could be the 91 day treasury note, 10 year treasury bonds, or other government backed securities.

MPT also utilizes the concept that one can borrow the risk-free asset and increase the overall return of the portfolio.  Of course, there is risk in borrowing if you’re wrong, or your timing is bad as the last year or so has been for most investors so this is deemed a “negative risk-free” weighting.

The Flaw of MPT (and the Sharpe Ratio)

It’s easy to be a Monday morning quarterback and critique investment advice after the fact.  This is easily done for MPT as the last year or so, no real amount of diversification has worked for investors, leaving many financial advisors looking for answers.  This is not the “Flaw” I am addressing.

The Flaw I’m addressing is in MPT’ and the Sharpe Ratio assumption that there is such a thing as a “risk-free” asset. The assumption is that the U.S. dollar is risk free.

Yes, the dollar has had a good track record up until about the year 2000.  This is because there was no competition to the U.S. dollar.  But as of 2000 and beyond,  there have surfaced more places that investors can park money including the Euro and even Gold (via the many ETFs that have arrived).  The Euro itself has been another nail in the U.S. dollar coffin.

Since the year 2000, we’ve seen a decoupling of gold, the Euro and the U.S. dollar.

So what was once viewed as “risk-free” in the days of the creation of MPT and later the Sharpe Ratio, is now viewed more and more by astute investors as an asset that bears quite a bit of risk. Just ask China and Japan who, along with the U.S. public, hold most of the Treasury debt (but remember that the U.S. media along with the Treasury and the Fed do a good job of disguising what’s really going on with the U.S. dollar).

During Geithner’s visit to China in early June, Chinese students laughed when Geithner said “U.S. assets are safe.”  Yet when you Google “Chinese students laugh Geithner” there are no U.S. media outlets that address the “laughing”aspect to the story.  The only media outlets that picked up the Chinese students “laughing” story were foreign like the Telegraph.

The Flaw in Most Portfolios Today

The Flaw in most portfolios today is there is too much faith in the U.S. dollar.  Most advisors today still adhere to the same diversification pattern of a certain percentage in stocks (mostly U.S.), a smaller percentage in bonds (typically all U.S. Government and Corporate), and a very small percentage in Cash (the U.S. dollar).  A few had started to diversify a small portion into certain types of REIT’s (mostly because of the nice commissions).

This means that at a minimum, 80″% of one’s portfolio is subject to U.S. dollar risk and in many cases, 100%.  So if the U.S. dollar portion of your portfolio goes up 10% and the U.S. dollar falls 10%, you haven’t gained any true wealth (purchasing power).

Only Gold Counteracts the Fall of the U.S. Dollar

For the most part, only gold can counteract the fall of the U.S. dollar.  So why isn’t your financial advisor recommending it?

Be aware that I do realize there are other avenues to counteract the dollar like TIPS and Silver, and possibly even oil.  While TIPS are supposed to be an inflation hedge, it is a hedge of the government manipulated CPI numbers which has been negative of late while the dollar has been declining.  Silver and oil are more volatile than gold and wouldn’t be as prudent (although they have their place in a diversified portfolio).

If you’ve noticed, as of this writing, the dollar index is breaking to new current lows, hovering around the 78 mark and gold is close to the $1,000 mark, only about $60 from its all-time high.

The really biggest Flaw one can make today is not diversifying into gold.  This doesn’t mean putting all your money into gold.  But it does mean to rethink your understanding of what a “risk-free” asset is.  The Chinese students seem to know.

1 MPT concepts taken from Wiki definitions and Investopedia and summarized for simplicity of understanding 2 Sharpe shared the Nobel Prize with Markowitz, creator of MPT.

About Doug Eberhardt

Doug Eberhardt is a 28 year financial services veteran and precious metals broker selling gold and silver at 1% over wholesale cost. Doug has written a book to help investors understand how gold and silver fit into a diversified portfolio, how to buy gold and silver, and what metals to buy. The book; “Buy Gold and Silver Safely” is available by clicking here Contact phone number for Buy Gold and Silver Safely is 888-604-6534