Face it, after reading about the 5^th Deadly Sin (see “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 5th Deadly Sin – Misapplied Asset Allocation,” FiduciaryNews.com, June 9, 2015), you knew this one was coming.

Truth be told, we’ve been sitting on this for quite some time – almost two decades in fact. Why?

Because we didn’t feel the world was ready to handle the truth. We’re still kind of leery that we might be chased by angry villagers with their pitchforks and torches. But we’re confident (with a bit of irony as you’ll see in a moment), rational minds will prevail. (Of course, we have no such confidence when it comes to the 7^th Deadly Sin).

What if everything we were taught about investment theory turned out to be wrong? That’s the question on the cusp of being answered in a new series of articles (see “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 6th Deadly Sin – Not-So ‘Modern’ Portfolio Theory,” FiduciaryNews.com, September 7, 2016).

That Modern Portfolio Theory (MPT) is the subject of the Deadly Sin series shouldn’t surprise many. There have been a growing number of articles in recent years attesting to the failure of the nearly three-generation-old theory.

A better question might be: Why have its failings been covered up for so long? After all, as the above series explains, no sooner had MPT become “generally accepted” than those paying attention began to expose its failures.

If you’re a student of investing and regulators, you’ve already discovered there’s an awful tendency for government administrators to lag behind. Just when the powers that be endorse something, that something turns out to be not so great as previously thought.

By then, though, it’s become “too big to fail.” The industry has entrenched itself into the new orthodoxy. It costs too much to switch gears; thus, the inefficiency not only continues, but it grows.

There’s a lesson I remember from business school involving sunk costs. It goes something like this: If you’re going to determine the ROI on any particular marginal expenditure, the return must be calculated solely on that marginal expenditure.

You can’t include any previous investments, a.k.a., “sunk costs.” If you pay attention to sunk costs, you might not make investments you might otherwise make or you might not cut your losses before it’s too late.

For example, and this may be appropriate as the polls show Trump beginning to extend his lead, I recently spoke to someone who works for a major health insurance firm. With bad news on Obamacare mounting, I asked him how he thought the failing program would be repealed and replaced.

He quickly rebuffed the question, saying the law would never be repealed. I asked him, “Why?” His simple answer: His firm had just sunk millions of dollars developing systems for it over the last few years.

In a phrase, it’s too big to fail. Too much money has been invested and we can’t let that money go to waste, can we? It’s the same issue with MPT, and it explains why it’s taken so long for Captain Obvious to open his mouth.

Who are these vested interests?

I have talked to many of the usual suspects from the world of academia. For the most part, the old guard – the ones who came up with, promoted, and profited from MPT – remain its most ardent supporters. They are the ones with the greatest sunk costs. But they’re not the ones doing ground-breaking research today.

The younger researchers don’t even seriously discuss MPT as a viable option. They realize it contains too many documented flaws. It’s just not the kind of thing you want to stake your professional reputation on. They have no sunk costs in this decades-old theory.

So, who has the greatest sunk costs? Companies and individuals in the financial service industry have the greatest sunk costs.

From the firm point of view, just like my friend’s insurance company, they have invested far too much money in marketing, systems, and internal training to justify changing things.

From the individual point of view, if you’ve spent you’re entire career as a practitioner trained in all aspects of MPT, it’s difficult to change tunes this late in the game. Besides, you’ve got the regulator’s cover of it being a “generally accepted” investment theory (current research aside).

There remain portions of MPT which continue to make sense. For example, the relationship between perceived risk and expected returns retains its logical underpinnings.

Once you start getting beyond that, though, things begin to unravel. Maybe it can predict, maybe it can’t. But you can sure show people how it might, and you can get them to believe it will.

In 1951, Harry Markowitz began working on the paper that would eventual evolve into Modern Portfolio Theory. That same year, in the Third Edition of the seminal Security Analysis, Ben Graham said, with eerie foresight, “We find these forward projections of the past to be misleading at least as often as they are useful.”

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