Sometimes, another person's real-life experience can make a theoretical concept understandable. Today, I attended a lecture in Orlando and listened to a person describe such an experience.
(Truth In Blogging: Modern Portfolio Theory is the most widely-accepted theory of investment management, but I have written numerous times about my reservations with this theory. His experience exemplifies just one reservation with it.)
One of the basic concepts of Modern Portfolio Theory is that all investors are rational individuals making decisions in their own self-interest. Because their interests vary, their decisions will vary but will always be rational and independent. This is a fancy way of saying they are non-correlated.
It also explains how asset classes react to each other. They are non-correlated, which means some will go up while others go down. This concept of being non-correlated is important to understand Modern Portfolio Theory.
Our speaker told of his experience when he boarded flight 1549 on January 15, 2009, flying from New York to Charlotte, with 150 non-correlated passengers, who each had their own plans for the future. However, shortly after lifting-off, the plane was "attacked by the birds of Hell," causing the plane to lose power. The plane became quiet as it started descending -- until it landed on the Hudson River and then floated five miles downstream.
Most interestingly, he described the four and a half minutes they spent, after losing power but before they learned their fate by landing in the freezing river. The 150 non-correlated individuals became one - staring into the face of death. They all wanted the same thing -- to avoid death. They became fully correlated to each other.
This, he explained is the problem with Modern Portfolio Theory. Investors are non-correlated -- until they get scared. Then, they just want to sell. Our speaker even explained that the brain uses the same neural pathway for the fear of airplane crashes and the fear of stock market crashes.
That was an obvious result during the 2008/9 crash. Investors behaved the same - they sold. Asset classes behaved the same - they fell. In a crisis, decisions become correlated.
As I have said before: Modern Portfolio Theory works great . . . until it doesn't!
(Truth In Blogging: Modern Portfolio Theory is the most widely-accepted theory of investment management, but I have written numerous times about my reservations with this theory. His experience exemplifies just one reservation with it.)
One of the basic concepts of Modern Portfolio Theory is that all investors are rational individuals making decisions in their own self-interest. Because their interests vary, their decisions will vary but will always be rational and independent. This is a fancy way of saying they are non-correlated.
It also explains how asset classes react to each other. They are non-correlated, which means some will go up while others go down. This concept of being non-correlated is important to understand Modern Portfolio Theory.
Our speaker told of his experience when he boarded flight 1549 on January 15, 2009, flying from New York to Charlotte, with 150 non-correlated passengers, who each had their own plans for the future. However, shortly after lifting-off, the plane was "attacked by the birds of Hell," causing the plane to lose power. The plane became quiet as it started descending -- until it landed on the Hudson River and then floated five miles downstream.
Most interestingly, he described the four and a half minutes they spent, after losing power but before they learned their fate by landing in the freezing river. The 150 non-correlated individuals became one - staring into the face of death. They all wanted the same thing -- to avoid death. They became fully correlated to each other.
This, he explained is the problem with Modern Portfolio Theory. Investors are non-correlated -- until they get scared. Then, they just want to sell. Our speaker even explained that the brain uses the same neural pathway for the fear of airplane crashes and the fear of stock market crashes.
That was an obvious result during the 2008/9 crash. Investors behaved the same - they sold. Asset classes behaved the same - they fell. In a crisis, decisions become correlated.
As I have said before: Modern Portfolio Theory works great . . . until it doesn't!
