If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.
In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”
Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution.