by John Mauldin, GoldSeek:

“Premature optimization is the root of all evil…”

– Donald Knuth, from his 1974 Turing Award lecture

This is the second of two letters that I think will be among the most important I’ve ever written. These letters set out my philosophy about how we have to invest in the coming days and years. They are the result of my years spent working with clients and money managers and thinking about the economic and particularly the macroeconomic world. Because of some of the developments I will be discussing, I think the future is likely to be extremely challenging for traditional portfolio allocation models. In these letters I also discuss some of the changes in my thinking about the new developments in markets that allow us to more quickly adapt to a changing environment – even when we don’t know in advance what that environment will be. I hope you today’s letter helpful. At the end I offer a link to a special report with more details.

Last week I discussed what I think will be the fallout from the Great Reset, when the massive amounts of global (and especially government) debt and the bubble in government promises will have to be dealt with. I think we’ll see a period of great volatility in the markets.

I offered a solution for dealing with this complexity and uncertainty in the markets by diversifying trading strategies. But that diversification must reflect a rethinking of Modern Portfolio Theory, including a significant reshaping of valuations in asset classes. We’ll deal with those topics today.

Modern Portfolio Theory 2.0

I think successful investing in the future will use a variation of Modern Portfolio Theory. MPT argues that you should diversify among noncorrelated asset classes to reduce overall portfolio volatility. That strategy is wonderful when asset classes are truly noncorrelated – but we found out in 2009 that noncorrelation isn’t a reality anymore. Going forward, I think it will be more useful to diversify among noncorrelated trading strategies that are not committed to a buy-and-hold process for any particular asset classes. Call it MPT 2.0.

There’s a story here about how my thinking has changed on how we deal with Modern Portfolio Theory. About a decade ago, I gave the luncheon keynote speech at a major alternative investment (hedge fund) conference, on why I thought Modern Portfolio Theory no longer worked. My talk had to do with the rising correlation among asset classes and was an argument for active management and, yes, hedge funds (which of course the audience liked). The next year the conference organizers invited Harry Markowitz, the Nobel Prize winner who developed the theory, to do the same luncheon keynote. That year, I was speaking at the conference later in the day.

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