Modern Portfolio Theory in the Modern Economy: Mpt During the Credit Crisis 0f 2008
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Modern Portfolio Theory in the Modern Economy: MPT During the Credit Crisis 0f 2008
Abstract
There are various theories of risk and return as it pertains to measuring and predicting investment return in a portfolio- one of the oldest and most prominent being Modern Portfolio Theory .An example of a hypothetical portfolio utilizing the principles of MPT invested during the credit crisis of late 2008/early 2009 will be utilized in part. In direct application, does Modern Portfolio theory hold strong during a major financial crisis? Past research will be compared to present the mechanics and applications of MPT order to answer the questions poised and to create hypothetical portfolios based on past fund performance during the time period of 2007 -2010. It is expected that a portfolio using MPT would not have performed significantly better than any other less diversified investment.
Contents
Introduction……………………………………..........................................................................4-7
Credit Crisis
Thesis Statement
Modern Portfolio Defined
Prior Research
Prediction
Method…………………………………………………….........................................................8-9
Parameters/ Source of Portfolios
Results……………………………………………………......................................................10-19 A. Application/ graphs
Conclusion…………………………………………...............………………………............19-20
Restatement of Thesis
Discussion of Results
Limitations
Recommendation
Modern Portfolio Theory in the Modern Economy: MPT during the Credit Crisis 0f 2008
The latest credit crisis was considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. It is agreed by most that the triggering event to the crisis was the subprime mortgage market. On September 15th 2008, the Dow closed down 499 points, which at that time was a major shock. Within the next month the Dow would drop below 10,000 for the first time since 2004. (Altman 2009) A majority of investors in the stock market during that time suffered substantial paper losses, many more unfortunate locking in those losses by selling equity and fleeing to money markets or short term bonds for security. Those hit the worst were those invested primarily in equity securities. Could a well planned investment portfolio, based upon the principles of Modern Portfolio Theory, have acted as a strong barrier against the huge market crash?
This research paper will attempt to discover whether or not MPT it is as effective in a modern economy, and during a modern economic crisis. Comparisons are made based on prior academic research, and based on a hypothetical portfolio of Vanguard mutual funds invested during and around the credit crisis of 2008. Using a portfolio based on the investment principals of Modern Portfolio Theory, could a diversified portfolio “survived” more so than a non diversified one during the credit crisis?
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. (Freeman 2011) An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Simply put, it is possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. (Freeman 2001) This frontier is a graphic representation of the best way to construct a portfolio that can include both "risky" (e.g., stocks, bonds) and "riskless" (e.g., Treasury bills) assets.
Modern Portfolio Theory is based upon four major components summarized below (Baker 2011): 1. Investors are risk averse. Investors are more concerned with risk than with reward. Therefore rational investors will not accept additional risk unless the level of return compensates them for this risk. 2. Security markets are efficient. The Efficient Market Hypothesis states that while the returns of different securities may vary as new information becomes available; these variations are inherently random and unpredictable. As new information enters the market it is quickly reflected in the prices of securities, and thus temporary pricing discrepancies are extremely difficult, if not impossible, to exploit for profit. 3. Focus on the portfolio as a whole and not on individual securities. The risk and reward characteristics of all of the portfolio’s holdings should be analyzed as one, with assumptions that equities offer higher returns than bonds. How one’s investment dollars are allocated far outweighs the potential effects of individual security selection and market timing. 4. Every risk level has a corresponding optimal combination of asset classes that maximizes returns. Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, but rather the lack of correlation of one asset to another. The higher a correlation between two investments, the more likely they are to move in the same direction. A higher lack of correlation equates to a greater level of diversification. A major flaw with MPT is that it makes certain assumptions which may or may not always happen: (Bow, Dow, & Newson 2008)
A. Volatility as a measure of risk
B. Exclusion of correlation of 1.00
C. No transaction costs
D. Liquidity is infinite
E. Investors act rationally
F. Investors as a group look at risk-return relationships over the same time horizon
G. Investors as a group have similar views on how they measure risk
H. All assets can be bought and sold in the market
Politics and investor psychology have no effect on the markets
Butt, Choudhry, Landuyt, and Turner (2010) Suggest that MPT only works well in a bull market, and argue that this was proven by the credit crisis of 2008:
“The problem is that MPT and the diversification argument, like so many supposedly good investment ideas, only works in a bull market, when investors pay at least lip-service to “fundamentals” and apply some logic in share valuation (and even then they don’t always; for example, thedot.com crash). In a bear market, or in any period of negative sentiment, all asset prices and markets go down. And in times of crises, as we have observed during 2007-08, correlation between asset classes is practically unity.”
MPT is all about diversification, but this may be enough to survive major financial disaster, especially when we consider that many of the basis assumptions made by MPT will not always be in place. As presented, many researchers argue that MPT is flawed, and that diversification may not be the cure all in an investment portfolio. It is further suggested that a diversified portfolio would not have helped in the credit crisis in 2008. My prediction is that, upon utilizing the hypothetical MPT portfolio against a pure equity or pure fixed income (non diversified portfolios), there will not be a significant difference between gain or loss for that period. I agree with previous research that suggests the MPT works best in a bull market where specific assumptions are in place.
Method
Materials: Vanguard mutual funds were used as the source for the model portfolios, along with actual historical figures and charts from July 2007- July 2010 from the Vanguard.com (2011) website. Line graphs were created from investment tools on Morningstar.com (2001)Four portfolios were compared for the purposes of the study, all based on a beginning balances of $10,000. A balanced, diversified fund, the Vanguard Star fund, was selected to use as the model for MPT. This was referred to as Portfolio A. This fund was chosen because it is diversified in 11 different subcategories of stocks and bond funds which include: (Vanguard.com, 2011)
Portfolio A: Vanguard STAR Fund (VGSTX)
Portfolio composition Allocation to underlying funds
|Ranking |Fund |Percentage |
|by | | |
|Percentage | | |
|1 |Vanguard Windsor II Fund Investor Shares |14.2% |
|2 |Vanguard Short-Term Investment-Grade Fund Investor Shares |12.3% |
|3 |Vanguard Long-Term Investment-Grade Fund Investor Shares |12.3% |
|4 |Vanguard GNMA Fund Investor Shares |12.3% |
|5 |Vanguard International Growth Fund Investor Shares |9.5% |
|6 |Vanguard International Value Fund |9.5% |
|7 |Vanguard Windsor Fund Investor Shares |7.8% |
|8 |Vanguard U.S. Growth Fund Investor Shares |6.1% |
|9 |Vanguard Morgan Growth Fund Investor Shares |6.1% |
|10 |Vanguard PRIMECAP Fund Investor Shares |6.1% |
|11 |Vanguard Explorer Fund Investor Shares |3.8% |
|Total |— |100.0% |
Three other Funds were selected to serve as control groups for the MPT diversified fund.
Portfolio B consists of U.S. Equity stock only, the Total Stock Market fund (VTSMX) which is diversified by sub type of equity only-small, medium, and large cap equity stock.
Portfolio B: Vanguard Total Stock Market Index Fund (VTSMX)
Portfolio C consist of the Vanguard Total Bond Market Index Fund (VBMFX),which is diversified only by subcategory of bonds- corporate and government, and all bond maturities.
Portfolio C: Vanguard Total Bond Market Index Fund (VBMFX)
Portfolio composition distribution by bond credit quality (% of fund)
|Type |Percentage |
|U.S. Government |70.2% |
|Aaa |3.6% |
|Aa |6.4% |
|A |10.3% |
|Baa |9.5% |
|< Baa |0.0% |
|Total |100.0% |
Portfolio D consists of the Vanguard Balanced Index Fund (VBINX) a simplified balanced portfolio;which is diversified into roughly 60% stock and 40% bonds.
Portfolio D: Vanguard Balanced Index Fund (VBINX)
Portfolio Composition:
|Type |Percentage |
|US Bonds |41.00% |
|US Stock |59.00% |
|Money Market |0.00% |
However, this balanced fund is not diversified in the same standard as a portfolio applying the principles of MPT. This simplified diversified portfolio will be compared, along with the stock only and bond only funds, to the more complicated diversified STAR fund, which more closely follows the principles of MPT. The STAR fund uses multiple sub classes of US Stock, International Stock, and Bond funds to create a deeper level of diversification.
Procedure:
Graphs were generated using MorningStar Fin Analyzer ( morningstar.com) for each portfolio for the following ranges of time:
Pre- Credit Crisis: July 2007-July 2008
During Credit Crisis: July 2008-July 2009
Post Credit Crisis: July 2009-July 2010
Results
Portfolio A Vanguard STAR Fund (VGSTX) MPT MODEL:
Pre Credit Crisis:July 2007-July 2008
During Credit Crisis: July 2008-July 2009
Post Credit Crisis: July 2009-July 2010
Three year Summary 2007-2010 for Vanguard Star Fund:
An investor starting with a balance of $10,000, invested in the STAR fund from July 2007- July 2010 would have a loss of 1,000 or 10% at the end of three years. This is while using the principals of diversification for MPT.
Portfolio B: Vanguard Total Stock Market Index Fund (VTSMX)
Pre Credit Crisis:July 2007-July 2008
During Credit Crisis: July 2008-July 2009
Post Credit Crisis: July 2009-July 2010
Three year Summary 2007-2010 for Vanguard Total Stock Market:
An investor starting with a balance of $10,000, invested in the Vanguard Total Stock Market from July 2007- July 2010 would have a loss of apx $2,500 or 25% at the end of three years. This is by investing only in the US stock market.
Portfolio C: Vanguard Total Bond Market Index Fund (VBMFX)
Pre Credit Crisis:July 2007-July 2008
During Credit Crisis: July 2008-July 2009
Post Credit Crisis: July 2009-July 2010
Three year Summary 2007-2010 for Vanguard Total Bond Market:
An investor starting with a balance of $10,000, invested in the Vanguard Total Bond Market from July 2007- July 2010 would have a gain of apx $2,400 or 24% at the end of three years. This is by investing only in the US bond market.
Portfolio D: Vanguard Balanced Index Fund (VBINX)
Pre Credit Crisis:July 2007-July 2008
During Credit Crisis: July 2008-July 2009
Post Credit Crisis: July 2009-July 2010
Three year Summary 2007-2010 for Vanguard Balanced Index Fund:
An investor starting with a balance of $10,000, invested in the Vanguard Balanced Index Fund from July 2007- July 2010 would have a loss of apx $800 or 8% at the end of three years. This is by investing in a simple diversification of 60 % US stock, 40% US bonds.
Portfolio Summary Combined 3 yr time period of Credit Crisis 2007-2010
|Portfolio/Fund |Loss/Gain |
|Portfolio A MPT MODEL/Vanguard STAR Fund (VGSTX) |-10.00% |
|Portfolio B/Vanguard Total Stock Market Index Fund (VTSMX) |-25.00% |
|Portfolio C/Vanguard Total Bond Market Index Fund (VBMFX) |24.00% |
|Portfolio D/Vanguard Balanced Index Fund (VBINX) |-8.00% |
Conclusion
My results support my original prediction of modern portfolio theory in direct application during a major market crash. In direct comparison of four hypothetical portfolios; one a close model of MPT diversification principals, there was no significant advance to to MPT portfolio during the credit crisis. As suggested by earlier researchers, ( Sharpe 1991) MPT does not perform to any advantage in a bear market. In looking at the summary graphs and numbers of the time period 2007-2010, the two extreme portfolios of Total Stock Market Index and Total Bond Market Index performed nearly opposite of each other. Other the three year period, Vanguard Total Stock loss %25, while Vanguard Total bond fund gained 24% return, as would be expected since this securities perform opposite of each other. The two diversified portfolios composed of stocks and bonds had shielded losses. The simple diversified fund, Vanguard Balanced Index Fund, loss 8% over the 3 year period, 2% less than the loss of the more complicated diversification of the Vanguard Star Fund which saw a loss of 8%. Based on the claims of the MPT, it would have been expected that a fund or portfolio with a high degree of subcategory diversification would have done very well during the credit crisis. However, based on results, it can be concluded that a simple combination of stocks and bonds in a portfolio would be sufficient to limit losses during market turmoil. Some limitations of this research included using only Vanguard Funds, results may have been different if alternate fund families had been used. Also, using actual individual stocks and bonds instead of mutual funds may have altered results. Finally, more control groups or portfolios could have been tested for more accurate comparison of results. Future research may include more control groups, security types, and a comparison of other risk/return theories.
References
Altman, R. (2009). The great crash, 2008-a geopolitical setback for the west. Foreign Affairs, 24(2), 45-52.
Bai, L., Dow III, B., & Newsom, P. (2008). THE CASE OF SIMULATING THE CHOICES OF MONEY MANGERS BY APPLYING MODERN PORTFOLIO THEORY USING REAL STOCK PRICE DATA. Journal of Economics & Economic Education Research, 9(3), 67-90. Retrieved from EBSCOhost.
Baker, K. (2011). Capital budgeting valuation: financial analysis for today's investment projects. (1 ed., pp. 324-328). Boston: Wiley.
Butt, K, M Choudhry, G Landuyt, and S Turner. "Modern Portfolio Theory and the Myth of Diversification." World Commerce Review. 1.3 n. page. Web. 24 Sep. 2011. .
Caccioli, F., Marsili, M., & Vivo, P. (2009). Eroding market stability by proliferation of financial instruments. THE EUROPEAN PHYS ICAL JOURNAL , 71, 467–479 .
Freeman L. 'Efficient frontier' shows best investment options. Ophthalmology Times [serial online]. July 15, 2001;26(14):18. Available from: Academic Search Premier, Ipswich, MA. Accessed September 22, 2011.
Morningstar Mutual fund anaylzer. (2011, September 26). Retrieved from http://www.morningstar.com/Cover/Funds.aspx
Resnik, B. L. (2010). Did Modern Portfolio Theory Fail Investors in the Credit Crisis?. CPA Journal, 80(10), 10-12. Retrieved from EBSCOhost.
Sharpe, W. (1991). Capital-asset prices: a theory of market equilibrium under. Journal of Finance, 19(3),23-38
Vanguard funds. (n.d.). Retrieved from https://personal.vanguard.com/us/funds
