Modern Portfolio Theory (MPT) alleges that well-diversified securities and targeted cash levels will insulate investors during market downturns. Folks stopped talking about MPT after the 2008 crash, but the discussion kicked up again, right on schedule, when financial markets roared back to life at the start of the last decade. In fact, Wall Street did everything in its power between 2010 and 2015 to induce amnesia about the underlying risk of this widely adopted approach.
Making matters worse, we've transitioned into all sorts of passive investment schemes in the past few years, in which small and medium-sized retail customers can bypass high management fees and have a robot handle their money. That's all well and good when the markets are ticking higher, but as I learned doing several dozen robo-broker reviews in 2019, many of the algorithms running this money are copycatting the same unsubstantiated assumptions.
That makes current events especially dangerous because investors worldwide have been lulled into a sense of complacency, now relying on financial markets and their robots to save their shrinking profits after others get shaken out of the game. Unfortunately, as we learned in 2000 and 2008, bear markets can outlast the most optimistic investor and not bottom out until he or she finally capitulates.
Modern investors and their algorithms often forget the most important part of MPT, which is that "cash is king" when a foul wind blows. A 0.00% return looks like a fortune after the Dow drops 5,000 or 10,000 points, limiting anxiety and fear, which are the two biggest obstacles to profitability and liquidity during a bear market. Sadly, most retirement and trading accounts are stuffed with equities despite the downturn, due to Wall Street's endless pressure to not "miss out."
The Myth of Portfolio Diversity
Classic MPT divides allocations between equities, bonds, and cash. Index and sector funds used for most equity exposure are theoretically designed to spread risk across diverse market groups in order to reduce losses during downturns. However, this is pure myth because, as you've seen in recent weeks, correlations across market groups soar to nearly 100% during periods of high volatility, meaning everything is rising or falling at the same time.
Bond exposure looks like a life saver at the moment, but future returns are likely to crash due to the transition into zero or even negative interest rates by the Federal Reserve. Ominously, negative rates place a burden on cash, with the government charging you to hold dollars and cents. That will makes matters worse if this crisis persists because spending may evaporate while families shift their attention away from financial markets and to the health of their loved ones.
Steps You Can Take Now
A few simple steps can relieve anxiety while we wait for the COVID impact to ease in the United States and around the world. First, reexamine your cash position and take some losses, building a sizeable cash barrier to keep the bogeyman at bay. Second, consider hedging your positions, but only if you're skilled at options trading. Inexperienced investors should avoid that venue because it can be a straight shot to economic ruin if you don't know what you're doing.
Last and most importantly, 99% of all retail traders and investors should stand aside and not open new positions until the coast is clear. You'll know that's happening when the CBOE Volatility Index (VIX) drops back into the 20s. Considering this volatility indicator reached almost 100 when the markets crashed in October 2008, you could be hunkering down and avoiding the markets for several months, at a minimum.
The Bottom Line
Disclosure: The author held no positions in the aforementioned securities at the time of publication.