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Background

In 1987, I went to work as a pension actuary for consulting firm Towers Perrin (now Towers Watson). While I was still finding my way to the office coffee machine, my newly assigned client lost $1 billion in pension assets in one day. It was October 19, 1987, Black Monday.

After Black Monday, everyone began talking about risk management. On the institutional side, portfolios were hard hit just when new accounting standards required that pension plans be reflected in corporate earnings. Some of the discussion was on practical ways to immunize corporate earnings from the negative impacts of pension asset declines. But a lot of the discussion was about MPT and the most common portfolio structures, mean-variance-optimized (MVO) portfolios.

In an investigation into the causes of the 1987 crash, much of the blame was aimed at Leland O’Brien and Rubinstein (LOR), the inventors of portfolio insurance, a product designed to reduce the risk in pension and other institutional funds. LOR was accused of contributing to the crash with program trading that reduced exposure to assets as those assets declined in value. The idea was good, but in execution, it created a cycle of selling that couldn’t be stopped once it got started. Because the bull market that began in 1982 was still intact and the issues were more technical than structural, the market recovered quickly.

Portfolio insurance was part of a growing trend toward hedging market risk. There also seemed to be a growing division between those who thought MVO was still the best way to structure portfolios and those who saw a fatal flaw in the application of the theory. Proponents of MPT thought it could be fixed. They recommended some changes to improve the model, such as expanding the portfolio universe to include more asset types and geographies and improvements in the way correlation coefficients were calculated.

The critics disagreed. They pointed to past market crashes and said there was a clear history of correlation coefficients converging. They said that the diversification model breaks down under stress and, in market crashes, that “correlations go to one,” eliminating the benefits of diversification.

The 1997 Echo Crash and 1998 Asian Currency Crisis

Ten years after the 1987 crash, I started a hedge fund just before what was called the “echo crash.” On October 27, 1997, the Dow Jones Industrial Average fell 554 points, the largest point drop in the history of the index at the time.

This time, the macro economic story was more complicated. The market was already nervous about global issues such as the developing currency crisis in Asia and debt levels in Russia. In the United States, the beginning signs of structural issues were showing and nervousness about a possible inflection point in one of the longest-running bull markets in history. (The bull market started in 1982 with the Dow Jones Industrial Average at just over 800 and ran through January 2000, when it reached almost 12,000.)

The following year, 1998, Asia did in fact experience a currency crisis and Russia defaulted on its debt. The extent to which the U.S. markets were affected proved how interconnected the global economy had become. Also in 1998, a group of Nobel Prize winners and quantitative investors at Long Term Capital Management (LTCM) almost collapsed the U.S. financial system. I had been through the savings and loan crisis as a consultant, but LTCM was my first experience with a systemic crisis as an asset manager. The Federal Reserve eventually stepped in to coordinate a bailout that avoided a larger banking contagion.

The arguments over MPT and portfolio construction continued. In fund management, there were incremental changes. The methods used to optimize allocations and define efficient frontiers were evolving, and hedge funds were making their way into more institutional portfolios and gaining popularity as an asset class.

The 2000–2002 Internet Bubble Crash

The turbulence in 1997 and 1998 turned out to be just warm-ups to the real show that began in early 2000. From March 2000 until the third quarter of 2002, the S&P 500 fell 49%. That was good compared to the NASDAQ. It fell 78%.

In 1999, before the problems started, I had already begun using a volatility-reducing strategy. The 1998 market had convinced me to start experimenting with hedging and various sell disciplines. The problem I was having, along with a lot of other people, was not letting investment-oriented risk management transform into pure trading. Especially since my fund was heavily weighted in emerging technology companies.

In late 1999 and early 2000, I started getting defensive and announced to my clients that our portfolios were prepared for as much as a 30% decline. I underestimated. During the brutal months ahead, many of our investments lost 50%—some much more.

In the asset management industry, this period seemed to me to represent a turning point. The severity of the broad market decline, combined with what was going on in Japan where equity markets were entering a second decade of decline, would, I thought, cause a serious reevaluation of risk management practices. For me personally, it certainly did.

With regard to portfolio theory, the evolution continued with new innovations—global tactical asset allocation (GTAA), global dynamic asset allocation (GDAA), further expansion of the asset universe, newer ways of optimizing allocations and core-satellite separation. The same ideas were filtering down to the retail investor and 401(k) plans in the form of target date and life-cycle plans.

The critics repeated what they had been saying all along: The structure was broken, and no amount of “tortured re-optimization” and other fine-tuning would do anything to solve the problem. What happened in 2008 proved they were right.

The 2008-2009 Global Financial Crisis

From its peak in 2008 to March 2009, the S&P 500 index fell by 57%. After this event, the climate of critical review seemed to change. The damage from the crisis was so deep and so widespread, people were determined to look at the event more realistically. Lawrence Siegel wrote a guest editorial for the Financial Analysts Journal in 2010 called “Black Turkeys”:

  • Nassim Nicholas Taleb has an elegant explanation for the global financial crisis of 2007–2009. It was a black swan. A black swan is a very bad event that is not easily foreseeable—because prior examples of it are not in the historical data record—but that happens anyway. My explanation is more prosaic: the crisis was a black turkey, an event that is everywhere in the data—it happens all the time—but to which one is willfully blind.3

Siegel gave several examples of major asset classes that experienced severe bear markets. The Dow Jones Industrial Average dropped 89 percent from 1929 to 1932, Japanese stocks dropped 82 percent from 1990 through 2009, the NASDAQ dropped 78 percent from 2000 to 2002, UK equities dropped 74 percent from 1972 to 1974, and others. The one that surprised me most was the 67 percent decline in long US Treasury bonds between 1941 and 1981.

Looking at the S&P 500 index decline of 57% in historical context, Siegel said, “There is no mystery to be explained. Markets fluctuate, often violently, and sometimes assets are worth a fraction of what you paid for them.” Earlier, before the crisis, Reinhart and Rogoff (2008) had released their report on major financial crises in 66 countries over a period of 800 years and found an average equity market decline of 55%.4

As a fund manager, I knew part of the problem I was facing was the severity of asset declines, but another part involved psychological reactions to market ups-and-downs. I knew volatility was having a dramatic effect on fund performance. What I did not realize was the magnitude of what volatility was doing to individual investor returns.

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