Thursday, April 02, 2015

Modern Portfolio Theory Before Hyperinflation

Modern portfolio theory (MPT) has been around since Ike was in the White House.  It's old enough to be Generation X's cranky parent, yelling at the neighborhood kids to get off the lawn.  It's also old enough to deserve some improvements.

The authors of MPT and related investment strategies were old enough to have lived through the Great Depression.  Images of people who lost everything from overconcentration in one stock, style, or sector made lasting impressions.  MPT's emphasis on diversification is a natural result.  Most investment theorists in the Anglo-West have not lived through a hyperinflating economy.  Using MPT to rebalance portfolios during hyperinflation poses hidden risks.

Fixed income investments comprise a significant allocation of many MPT models in the real world.  Bonds, notes, cash instruments, and other things denominated in a face amount of currency will rapidly turn worthless in a hyperinflationary economy.  Ask anyone who invested in Zimbabwe, Argentina, or Venezuela in the last decade.  MPT investors in those countries could be heard howling all the way across the Atlantic, if anyone listened.

Hyperinflation turns MPT inside out.  Asset allocations that include hard assets are far more likely to survive a hyperinflating economy than anything with fixed income.  Hard asset sectors like energy, agriculture, mining, and now infrastructure as an emerging theme will hold their worth through inflation because they produce output that can be valued in any currency.  They may even experience strong valuation growth during hyperinflation as investors rush to convert the declining power of their currencies into hard goods that will retain utility.  The end of hyperinflation will also end such rushed growth, but a productive farm will still be a farm.  A bond won't be the same at all.

Updating MPT for a highly inflationary economy does not require adjustments in risk-return calculations.  It does require the inclusion of other asset classes that do not behave like fixed income.  Consider that oil drillers and metal miners have been hit particularly hard in recent months by oversupply and declining world prices.  Consider also that lengthy monetary stimulus has pumped an unsustainable global bond market bubble.  Rebalancing means a rotation away from overconcentration in fixed income is due any time.  Underpriced hard assets are ready for any MPT-based portfolio manager with enough foresight to prepare for inflation.