I just received a John Mauldin e-mail. This is a small excerpt written by Esterling:
Modern Portfolio Theory ("MPT"), the model that acclaimed a Nobel Prize, should come with a warning label. "Use with caution. It's only as good as your assumptions." What did Harry Markowitz intend to impart with his ground-breaking research and what are the implications given a reasonable view of future long-term returns from today?
Harry Markowitz published his research titled "Portfolio Selection" in The Journal of Finance during 1952. He led with: "The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio. This paper is concerned with the second stage."
Help! What about the first stage? What do you mean that the assumptions are OUR responsibility?!!
It's been many decades since the article was first published. Many, many 'buy-and-hold" constituents have reiterated their mantra in concert with Dr. Markowitz. But that isn't what he intended. Yes, investors should only be rewarded for taking risks that can't be neutralized. Yes, stocks have more risk than bonds and over time have realized higher returns. BUT, what if your timeframe isn't 75 to 100 years and what if you are starting from a period of relatively high valuations and the expectation of below-average future returns?
Please Dr. Markowitz, help me with my 10 to 20 year investment horizon. For that, we can reflect upon historical 10 to 20 year horizons for your assumptions. That is the first stage to which Markowitz referred--before MPT can be applied to your portfolio.
Compounding: Never forget! Never not remember!