The Navigoe Blog

Modern Portfolio Theory and the 2020 Bear Market

Modern Portfolio Theory, Two Decades of Real Life Investing, and the 2020 Bear Market

Summary:

  • Modern Portfolio Theory (MPT) was emerging as the leading scientific investment approach in the 1980s.
  • A small number of firms started implementing the academic strategies of MPT over the course of the 1990s, of which Navigoe was one.
  • Navigoe’s approach to MPT was, and still is, a true interpretation; starting with global diversification implemented with anti-timing and anti-stock picking investment vehicles. 
  • We now have over two decades of real life experience with the academic concepts of MPT, as implemented by Navigoe and others.
  • Since 2000, stock markets have had two major market “crashes” accompanied with economic recessions, and the MPT has performed as expected.
  • We like to say that in 1999, MPT was academically sound, now in 2020, it has been market tested.
  • We are now in another bear market and perhaps a recession cycle. What have we learned so far in this century and how does it inform how we should react to the current situation?

Even to this day, unlike medicine, there is no rule that science must be applied to investment strategies or financial products. Imagine if a drug company could simply bring a drug to market and sell it to consumers with no testing of its risks or effectiveness. Even worse, what if your doctor’s compensation was based on the selling of such drugs to patients. While that scenario would be absurd in medicine today, it was not uncommon in the 1880s. What changed? In a word: science. Unfortunately for many investors, the financial services industry still operates like the wild west of medicine. But it does not have to be that way.

Starting as far back as the 1940s, economists began to apply empirical evidence tests to investing and all the different financial markets. This body of research has become known as Modern Portfolio Theory (MPT).  There have been numerous academics who have been awarded Nobel Prizes in Economics for their contribution to MPT. While there is vast research and evidence behind MPT, the majority of the financial services industry ignores or only provides lip service to the data. Why they do this is a longer article and beyond the scope of this blog. Let’s just say the science of MPT is contrary to the profit structure of most financial institutions.

As an economics student at UCLA in the 1980s, I was fascinated with investing, markets, financial planning and wealth. I took a class by one of the economists who was later awarded a Nobel Prize in Economics for MPT research. Upon graduation, I was excited to apply my knowledge and this new science of investing. Unfortunately, the industry was not. As a result, my only options to be able to build portfolios following the concepts of MPT was to start my own company, which I did in 1996.

It has been almost 25 years since I launched my firm and began implementing the empirical evidence of investing to client portfolios. The great news for our clients is that the theory has now been market tested, and it works. Over that period of time, we have experienced two major economic and stock crises. Both of which happened in the first decade of the 2000s.

Kicking off the 21st Century we saw a stock market bubble burst, what many of us refer to as the “Dot Com” bubble. But it was more complicated than that. From January of 2000 to December of 2002, the S&P 500 Index lost 37.61%. During that three year period, on September 11, 2001, the United States experienced the worst terrorist event in our nation’s history, which put us into a war which we are still fighting to this day. Also, in 2002, the SARS virus was first identified.

Concluding the first decade of the 21st Century, from March 2008 through February of 2009, the S&P 500 Index lost 43.32%. What has been dubbed the “Great Recession” was the result of a financial crisis due to easy lending. In 2009 and 2010, the H1N1 virus was identified in 214 countries, infected over 1.5 million people, killing around 285,000.

That was a terrible decade for the S&P 500 index, global economies and world health. For the decade, the S&P 500 Index lost on average 0.95% a year. A hypothetical $1,000,000 investment in January 2000 in the S&P 500 Index would have ended the decade in December of 2009 worth $910,000. Counter to that with Navigoe’s, MPT inspired all equity, globally diversified model portfolio, “Navigoe 100 Model,” which averaged 7.49% a year. A hypothetical $1,000,000 in the Navigoe 100 Model would have been worth $2,060,000. The message of the first decade was that global and factor diversification, as suggested by MPT, provided for a more typical investment outcome. 

On December 31st, 2009, looking back over the worst decade since the Great Depression, no one predicted that the US would have the longest period without a recession in the country’s history. The US stock market was referred to as the “lost decade” for investors. Yet the second decade in the 21st Century was a very good one for the economy and the S&P 500, which averaged 13.56% a year. A hypothetical $1,000,000 invested in January of 2010 would have ended December 2019 at $3,570,000. The rest of the world did not experience the same robust recovery from the Great Recession as the US, evidenced by the Navigoe 100 Model portfolio, which returned 8.21% for the decade, $1,000,000 ending at $2,200,000.

(Our preferred mutual fund management company, Dimensional Fund Advisors, wrote a short article comparing the first two decades of the 21st Century. Read it here.)

Over the 20 years, the S&P 500 Index averaged 6.06% a year – a little more than half its historical long-term average of 9.7%. That same 20 year period, the Navigoe 100 Model averaged 7.85% a year. Our hypothetical $1,000,000 would have grown to $3,240,000 in the S&P 500 compared to $4,530,000 in the Navigoe 100 Model. All in all, a pretty good showing for Modern Portfolio Theory as the theory was put to the test in the real world.

So what does this mean looking into this next decade? As of this writing, the S&P 500 Index is down more than 15% for the year. This is in large part due to the novel coronavirus, Covid-19, which has infected at least 116,000 causing over 4,200 deaths worldwide. Simply, no one knows the effect of Covid-19, nor does anyone know how global stock markets will react over the next months and years.

What we do know from MPT, both from the theory and the past 20 years of experience, is that a truly diversified portfolio provides a good expected outcome with respect to risk.

Here at Navigoe, we have been through this before. While we can not predict situations like we are currently experiencing, our academically sound investment strategy does not require us to. While we never know when a market crash will occur, or how and when the recovery will happen, we do know that there has never been a time in the history of equity markets when they have not recovered. Scientifically, that result is better than the best drugs medical science has created.

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