IF YOU KICK AROUND Wall Street for long enough, you’ll witness all kinds of investment fads—special purpose acquisition companies, cryptocurrencies, meme stocks, to name just a few. Each bubble differs, but the eventual comeuppance always feels brutally familiar.
But there aren’t just fads among investments. There are also fads among investment concepts. But while naïve investors tend to get caught up in investment bubbles, it’s the brainy types who fall in love with investment concepts, which they then promote with a religious zealot’s fervor.
Below are four such concepts. All ended up disappointing their most rabid fans. But despite that, each also has an important investment lesson to teach us.
1. Modern Portfolio Theory. When I started writing about personal finance in the late 1980s, cutting-edge financial advisors were focused on building portfolios that sat on the so-called efficient frontier. The efficient frontier—a crucial component of Modern Portfolio Theory—supposedly offers a menu of possible portfolios that’ll deliver the highest expected return for a given level of risk.
Those portfolio mixes were typically built on past performance, including the historical correlation among different investments. For instance, if an investment had generated high returns while performing quite differently from other asset classes, it would typically receive a hefty weighting in the portfolios found on the efficient frontier. After all, the investment in question promised to boost performance while also zigging when other investments were zagging, thus lowering a portfolio’s overall volatility.
Sound like a neat trick? Problem is, all this was usually based on past performance—and, as every investor eventually learns, past performance is no guarantee of future results. In the late 1980s, portfolios that sat on the efficient frontier typically included hefty allocations to Japanese stocks. The Japanese market had, of course, been generating gangbuster returns—an astonishing bull market that came to an equally astonishing end. More than 33 years later, the Nikkei remains some 30% below its year-end 1989 all-time high.
Lesson: While creating the ideal investment mix has proven far harder than running a portfolio optimizer that considers past risk and return, we shouldn’t dismiss the underlying goal—to construct a portfolio that includes uncorrelated assets. If you own just technology stocks, or just energy shares, or just high-dividend companies, your long-run returns may be fine, but the ride could be awfully rough and some investors won’t be able to stomach the turbulence. Want to sleep better at night? Make sure your portfolio is invested in all kinds of different stocks, and also includes at least a little money in bonds or cash investments.
2. Monte Carlo analysis. To state the obvious, high investment returns make it easier to achieve our investment goals. But the degree to which those returns help depends on when they occur during our lifetime. A bull market in our 20s won’t be much of a bonanza, because we likely won’t have much invested. But that same bull market in our 60s could allow us to afford every luxury on our retirement bucket list.
The importance of the sequence of returns captured the imagination of thoughtful financial advisors in the early 1990s, and led many to start using Monte Carlo analysis. What’s that? Imagine we took, say, the past 100 years of annual results for stocks, bonds, cash investments and inflation. We then assumed those annual results occurred in a random order and we repeated this exercise 1,000 times.
What we’d have are 1,000 possible market scenarios under which to examine how a portfolio might perform. Some of these hypothetical results would be great, and some would be terrible. But even if the results were terrible, would we still have enough money if we were saving for retirement or if we were drawing down a portfolio in retirement? Monte Carlo analysis can help us put a number on our plan’s chances of success.
But as Adam Grossman noted last week, Monte Carlo analysis offers a one-dimensional assessment of risk—one that hinges on the assumed investment returns. Still, that doesn’t mean we should ignore the key idea underlying Monte Carlo analysis.
Lesson: It isn’t average annual returns that matter, but rather what order we earn those returns. A bad sequence of returns can really bite if it happens early in retirement. Imagine quitting the workforce at the start of a year like 2022, when stocks plunged while the inflation rate jumped. Our comfortable retirement could be imperiled by the double whammy of falling investment prices and our own need for spending money. Faced with that threat, we should avoid selling stocks and minimize our portfolio withdrawals, thereby giving our nest egg a chance to recover.
3. Endowment model. During and after the brutal 2000-02 bear market, many investors—both individuals and institutions—cast around for ways to invest that weren’t so beholden to the vagaries of the stock market. They drew inspiration from David Swensen, Yale University’s chief investment officer, who had allocated a hefty portion of the university’s endowment to private equity, hedge funds, real estate and other alternative investments, and had done so with great success.
But the so-called endowment model has since lost some of its luster. The inability to sell many alternative investments amid market downturns caused major problems at some universities during the 2008 market crash. On top of that, the endowment model’s results over the past decade have been lackluster. Indeed, I’m no fan of alternative investments, which often involve high costs and occasionally produce wretched results. Want an investment that’ll hold up well during market declines? I’d favor the low-cost simplicity of short-term government bonds.
Still, while I don’t believe the endowment model is something everyday investors should emulate, underlying the model is a crucial idea—that endowments should turn their long time horizon to their advantage by allocating a significant portion of their assets to investments that may take years to come to fruition.
Lesson: Far too many investors focus far too heavily on short-run results, and yet most of us have surprisingly long time horizons, and we can take advantage of that by allocating a hefty portion of our portfolio to stocks.
For instance, if we’re age 65, we’ll probably spend no more than 40% of our portfolio’s current value over the next decade, and likely far less than 40% once subsequent investment gains are factored in. That means the time horizon for the remaining money is 10-plus years, which should be plenty of time to earn healthy stock market gains. What if some of our money will end up getting bequeathed to our grandchildren? The time horizon for those dollars might not be 10-plus years, but more than 60 years.
4. Factor investing. Modern Portfolio Theory posited that if investors held a diversified portfolio but upped the risk level—as measured by volatility—they could expect higher returns. But reality didn’t match the theory. Some segments of the stock market, such as smaller companies, value stocks and those with price momentum, were found to earn higher returns than could be explained by volatility alone.
In the 2000s, the growing list of market “anomalies” culminated in an explosion of so-called factor investing, also dubbed “smart beta.” Money managers rushed to market with exchange-traded index funds that tilted toward stocks with low volatility, price momentum, high gross corporate profitability and countless other attributes. But many of these funds ended up generating disappointing results, plus questions were raised about the validity of the underlying research—the so-called replication crisis, which found that many of the original studies underpinning factor investing didn’t hold up to close scrutiny.
Lesson: Like many investors who pay attention to academic research, I tilt my portfolio toward smaller-company and value stocks. That helped my results in 2022, but I strongly suspect it hasn’t helped over the long run. Still, I’m hopeful that these portfolio tilts will be a plus in the decade ahead, but I also readily concede that adding these tilts has introduced a key risk—the risk that my results will lag behind the broad market averages.
Indeed, while factor investing has disappointed many devotees, it’s highlighted an important insight: There’s more to risk than volatility. We also need to be alert to countless other investment risks, including inflation, deflation, lack of diversification, home bias, overconfidence, weak property rights, excessive leverage, badly lagging the market averages, sequence of returns, outright fraud, high investment costs and changing tax laws. And to that list, perhaps we should add one more: the risk we’ll fall in love with the latest investment concept.