Chapter Eighteen: Efficient Investing in an Inefficient Market - Why 60:40 is just another sell-side scam

Modern portfolio theory has been a failure for decades

William Sharpe won his Nobel prize in economics promoting the so-called Efficient Frontier and Capital Market Line which claims that by borrowing or lending at the “risk free” rate of return one can create a portfolio that combines the Markowitz efficient portfolio which Markowitz claimed could be constructed through diversification to produce the highest possible return for a given level of risk, and Sharpe demonstrated that through judicious use of leverage one could obtain higher returns or lower risk by combining the portfolio of stocks with that of treasuries.

The theory spawned a plethora of “fund managers” or “portfolio” managers who jumped on the bandwagon to sell services to pension funds, hedge funds, mutual funds, and other sell-side products and raise vast amount of money from the unwashed masses to be “efficiently invested”.

Risk under all of the above scenarious is defined as “volatility” in returns, an absurd definition of risk. Charlie Munger defined risk as the possibility of either permanent loss of capital or inadequate returns. Sharpe’s theory made “inadequate returns” a certainty rather than a method to avoid poor outcomes.

Pension fund trustees engaged highly-paid portfolio managers who persuaded them that the 60:40 rule (a portfolio comprising 60% equities and 40% bonds) was ideal with the weight of equities versus bonds tweaked at the edges as market conditions changed, a practice called “active management”. The outcome was the managers actively feathered their own nests while pensioners for decades suffered lower returns in return for less periodic volatility, as if the pensioner was concerned about whether the returns were evenly distributed over each measurement month or quarter on which the manager’s compensation often depended. In reality, pensions only concern was getting the pension they were promised, and with the “defined benefit” pensions that ruled the day for most of the past 50 years, the managers’ clients were the pension’s sponsoring employer, not the beneficiaries of the pension. Higher returns allowed employers to make lower pension contributions and lower returns required them to top up the plan with added monies on an annual basis.

This turned the pension management game on its head - the driving ethos was to smooth corporate earnings and ensure officers and directors whose stock options and bonuses reacted poorly to surprises, and smooth sailing encouraged pension managers to seek and get higher compensation for their skill in avoiding surprises.

Who suffered? Beneficiaries did, if their pension was determined by defined contribution rather than defined benefit, and the public purse for old-age pensions in funds such as the Canada Pension Plan (CPP) or the Ontario Municipal Retirement System (OMERS) pension plan where lower returns meant higher contributions from the taxpayer since the plans had fixed benefits and the government is on the hook for shortfalls.

So what happened?

Recent research going back to the late 1800’s produced compelling evidence of the obvious - 100% investment in equities outperformed the 60:40 portfolio theory by a wide margin. An October 2023 paper reported the obvious - 100% investment in equities would save trillions of dollars for government pension plans.

Wall Street’s reaction is predictable. Deny the research, find other justifications for the 60:40 rule, and hide. No one should be surprised. Fund managers are parasites to returns. Governments need ready markets for the excessive debt they peddle to raise money to buy votes and Wall Street is eager to help. U.S. and Canadian treasuries rely on inflation (itself a tax on the poorest in society) to repay debt by making the debt worth less at maturity and need the 60:40 rule to prevail so someone will be willing to buy their toxic paper.

The results of bond investment have been dismal over time, rarely greater than the rate of inflation over their full cycle with real returns on average in the 1.5% to 2.0% range. The range of outcomes expressed as monthly real returns by asset class is set out in the table below. Stocks produce higher returns in every country with few exceptions.

Democracies elect people who are popular, not necessarily well-educated, financially literate, or capable of managing anything. It should be no surprise they are victims of the financial industry and its complex and often obtuse theories. Common sense is rarely applied. Ordinary citizens carry the can.