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Bricks, Mortar and Gilts?

My attention was drawn to an article in the FTfm section of the FT: “The lost decade of financial fundamentalism”. The writer, Yuri Bender, recalls entering the halls of the London Business School back in the ‘90s and being “shocked by the financial fundamentalism of yesteryear’s professors” such as the Father of Modern Portfolio Theory, Harry Markowitz, and an atmosphere that was more Brezhnev’s Soviet Russia than Buffet’s gun-slinging Nebraska.

Bender goes on to note that, “It took a global crisis in 2008, the worst since the 1930s Depression, for heretics to emerge and question Mr Markowitz’s beliefs that risk and return were intrinsically linked and that diversification led to superior performance.”

Despite my abhorrence of the suggestion that markets are efficient – arguably considered the central tenet of Modern Portfolio Theory – I have always felt that Mr Markowitz has received a bad rap over the years. In an interview given in 2008, Markowitz noted that “Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that’s not true of a portfolio of correlated risks.” He was referring to collateralised mortgage obligations in which systematic risks were not considered, only the specific ones associated with the individual mortgages that had been packaged. “Selling people what sellers and buyers don’t understand, is not a good thing,” he said in the same interview.

What sellers and buyers didn’t understand of course was that the low historical volatility of US house prices – until the Global Financial Crisis, prices had risen since in the mid ‘70s – did not mean low risk. If anything it was the low volatility – akin to a volcano which has lay dormant for a while – that should have alerted people to the instability that was about to erupt.

But where did this belief that volatility-was-risk come from? This is where I think Mr Markowitz should be held to account. Tucked away towards the back of his seminal 1952 paper “Portfolio Selection” is the following sentence:

The concepts “yield” and “risk” appear frequently in financial writings. Usually if the term “yield” were replaced by “expected yield” or “expected return,” and “risk” by “variance of return,” little change of apparent meaning would result.

For Markowitz to build his mathematical models linking risk and return, he needed a measure of risk which could be easily calculated, and for this he chose “variance of return” or volatility. A sleight of hand, but one that would have enormous consequences. He even appends “apparent” to the word “meaning” perhaps an admission that there might be a more fundamental change that would result. This definition of risk had consequences back in the 2000s when investors thought housing was safe, and it has consequences today.

Where? Government bonds.

Bonds, like housing before them, have been rising pretty much continuously for as long as one can remember – in fact bonds have been rising for three and a half decades, almost as long as housing’s four decades. And they now look horribly over-valued – the 30 year inflation-linked Gilt yields -0.9% which means you lose 24% of your real capital if you buy and hold it to maturity.

Understanding risk is critical in investing. But this understanding must be gained through forward-looking valuation, not backward-looking volatility.

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Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

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