Financial News

This article represents part 2 of 3 in this series. Please see yesterday’s post as well as tomorrow’s for the full article.

If you are a professional in the investment management or economics fields, your entire system of decision making and the basis of everything you do in your workday may be wrong. While the following discussion may seem purely academic, it could actually have far-reaching practical implications for your personal and professional livelihood.

The two years preceding 2010 have resulted in a great deal of criticism of the ideas of rational economic actors and the “Efficient Markets Hypothesis” (EMH), the latter of which attempts to describe the pricing of securities markets. While an in-depth discussion of EMH and its validity is beyond the scope of this article, it is worthwhile to consider the antagonistic viewpoint on this subject, which states that markets are largely inefficient, and by extension means that it is possible for an investment portfolio manager to consistently beat the markets in terms of portfolio risk/return performance based on skill (which is contrary to EMH). But rather than make an absolute judgment on whether markets are 100% efficient or 100% inefficient, we can alternatively make the assumption that markets are sometimes “efficient” and are other times “inefficient.” If we are to take this latter stance, then how should portfolio managers best act for their clients?

It has been stated by many of the most influential minds in economics that “There is no such thing as a free lunch.” Despite this profound statement, Modern Portfolio Theory (MPT) has been credited by some with identifying the only known “free lunch” in economics.

In our last issue of the Compass & Crosshairs, the underlying theoretical tenets of what we will refer to as the “Global Development Systems” method of investment portfolio management were discussed in some detail. The following assertions were made and topics discussed (See the July ’09 issue for further information):

With the 2007-2009 financial system crisis and economic downturn as an impetus, some portfolio management professionals have begun to ascertain that Modern Portfolio Theory, as it has traditionally been applied, is due for an overhaul. In our last issue of the Compass & Crosshairs, in which we explored some of the various methods that might be applied under a “Multi-Contingency Investing” methodology, we briefly made mention of a Global Development Perspective Strategic Asset Allocation philosophy.

In our last two issues of the Compass & Crosshairs, we introduced the concept of multi-contingency investing and why the current financial/economic crisis has made this a new practice management imperative for financial planners, CPAs that provide financial planning services, and investment managers.

Since October of 2007, Modern Portfolio Theory has been under attack. One cannot read a single issue of the Financial Times or Wall Street Journal without encountering a statement from a behavioral finance academic, nouveau economist, or tactical portfolio manager proclaiming the death of Modern Portfolio Theory, rationalist economics, diversification, asset allocation, and the Efficient Markets Hypothesis.

In our last issue of 4Thought’s Compass & Crosshairs, we considered the ramifications of the world’s current financial crisis on the future of portfolio management philosophy. Specifically, we focused on the most recent arrows slung at Modern Portfolio Theory’s strategic asset allocation methodology, the most dominant form of asset management found among the world’ large institutional investment funds.

For those of us that have been watching the decimation of much of the banking and finance industry, it has become clear that finance-related firms’ compensation arrangements and ethical standards are being called into question through a blanket labeling of all finance industry professionals with some permutation of the word “crook.” The rapacious practices of real crooks, like Bernard Madoff et al., and the over-compensation of the officers of bailed-out financial institutions have clearly left a bad taste in the mouths of the public. This negative perception of the finance industry as a whole has in large part rubbed off on all individual professionals in the financial services, whether such gross agglomeration for the purposes of labeling is warranted or not.