Harry Markowitz Concept of Modern Portfolio Theory (MPT)
Louis Navelier made a name for himself when he first published an investment advisory service named MPT Review. MPT stands for “Modern Portfolio Theory,” a catchy, with it” name that had a following in the finance departments of America’s business schools. “Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper “Portfolio Selection,” (published in 1952 by the Journal of Finance) is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected returns based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
The idea of MPT sounds logical until one starts to ask serious questions
Harry Markowitz essentially said that one can reduce risk and get optimum portfolio performance by diversifying one’s portfolio with the best least risky stocks. Duh! The devil is always in the details. So let’s examine:
1 – What is risk? Wall Street has been obsessed with risk since stocks started trading under a button wood tree at the intersection of Wall Street and Broad Street. Over the years people have defined risk in many ways that always boil down to stocks that are safe, until they are not safe.
-AT&T (T) aka “Ma Bell” was considered to be the ultimate safe stock when I was growing up. Al Bell invented the telephone and a growth stock was created in 1899. For decades the company grew until telephones had saturated the country. During the period of no growth each generation swore by “T” as the ultimate dividend-paying safety stock. It didn’t matter that the stock was moving sideways and eventually started to erode in price. Grandma and our parents still swore by Ma Bell.
All the while Wall Street analysts stressed T’s dividend and rock solid earnings stability. The problem of course was that the company had stopped growing and competition had come in. Eventually T’s monopoly was destroyed and the company was replaced by a new AT&T in 1984.
-Beta is a measure of a stock’s volatility or risk- in theory the higher the beta, the more the risk. When stocks go down the high beta stocks go down more. Computers tell the Louis Naveliers of the world how to measure risk. – https://www.investopedia.com/terms/b/beta.asp –
The problem is that computers only measure the risk factors that programmers input- garbage in, garbage out.
-Other measures of risk are too numerous to mention and cannot be quantified by a computer. For instance, how does one measure the risk of a stock whose main business is in Putin’s Russia? How about a biotech company running low on cash while performing a phase 1 FDA study? No computer is going to tell you the risk. The market place will determine the risk. What about PE ratios? Amazon’s PE ratio is sky high yet the market has viewed Amazon as the greatest stock with the only risk being an antitrust action. Then along comes President Trump’s Tweets which threaten antitrust action against Amazon. Now what says your computer?
– Alpha is a measure of how well a stock or fund performs against a benchmark index. Investopedia defines Alpha as: “A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.”
– Alpha works until it doesn’t work. So who is defining Alpha and who is going to tell you your stock’s alpha is no longer so good?
– In my opinion, Alpha is better defined and equated by William O’Neal’s concept of Relative Strength (RS). I described RS in my article: How William O’Neal Revolutionized Investing. O’Neal’s financial newspaper, Investor’s Business Daily (IBD) constantly updates the RS rating of every stock. It is by far the best way to monitor a stocks behavior relative to the stock market.
2 – Louis Navelier’s definition of risk is strictly computer based and is flawed because it leaves out many necessary measures of risk control and human reasons to purchase stocks. (Click Here)
I have stated time and again that I am a former subscriber to Navelier’s newsletter and found his performance statistics to be suspect. I always found out after the fact that a stock that had already fallen was eliminated by his portfolios. Cramer on the other hand is very straightforward and does not eliminate stocks from his Action Alerts portfolio until the day after he notifies investors.
Also Navelier measures his worth based upon his performance verses the stock market. When I ran my hedge fund I measured my performance in two ways: 1 – beating a bull market. 2 – Not losing money in a bear market. In my view, anything else is lazy nonsense.
3 – A Filtered Approach
The best approach that I know was developed by Dr. Leo Barnes of the Zarb School of Business at Hofstra University. He came up with the concept of a series of hurdles that one should use in choosing a stock.
Here is an example of Stock filters. In this case every test must be met in order to hold a stock:
-IBD RS Rating over 90
-IBD EPS Rating over 90
-S&P 500 Index in Weinstein Stage 2 uptrend Stan Weinstein’s Staging Analysis and today’s Stock Market
-XYZ Stock in Weinstein Stage 2 uptrend
-Institutional Ownership over 25%
The above filters would have kept you out of all stocks for the past 2 months. Even if 4 out of the above 5 filters were passed, any stock would have been sold because one hurdle – S&P 500 is in stage 3 potential top and close to stage 4 downtrend – was not overcome.
If one wants to avoid as much risk as possible, a strict set of fundamental and technical trend following hurdles is as good as it gets.
Let’s Look at Louis Navelier’s problem by illustrating with the above approach:
STRL was downgraded by Navelier after its price fell from $19 to $11. The stock made a clear top and would have been sold avoiding a huge drawdown by using a simple trend following filter to avoid risk.
STRL exemplifies one of Navelier’s big problems – huge drawdowns. Just like Cramer, Navelier should be used as a tool. One should absolutely use his picks as a starting point for investigation, but then further scrutinize his picks using a filtered approach.
There is no perfect system for outperforming the stock market. But active investors can greatly improve upon the performance of the so called experts by using a filtered approach that keeps one out of stocks during bad times. Defense wins in sports and stocks. After a big decline, one may not catch the exact bottom, but one will not lose money or sleep using a filtered approach. Louis Navelier has suffered many drawdowns over 40% during stock market selloffs. I could not live with myself by saying, “yes I was down 40% but beat the market.”