In today’s world, there’s been a big push towards passive investments and away from active management. I’ve discussed in a previous post, Perhaps The Biggest Bubble Ever?, how much money has flowed into passive investments and the potential repercussions. Whether you use a human advisor or a digital advisor, investment allocations appear to be converging and are incredibly similar. They tend to use modern portfolio theory (MPT) which was developed in 1952 by Henry Markowitz. In reality, there’s not a lot modern about it. I believe there’s a better way to engineer investment allocations in today’s environment, but lets first start by exploring the basics and assumptions of MPT.
What is ‘Modern Portfolio Theory – MPT’?
Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper “Portfolio Selection,” published in 1952 by the Journal of Finance.
Assumptions of MPT
• Asset returns are normally distributed random variables.
• Investors attempt to maximize economic market returns.
• Investors are rational and avoid risk when possible.
• Investors all have access to the same sources of information for investment decisions.
• Investors share similar views on expected returns.
• Taxes and brokerage commissions are not considered.
• Investors are not large enough players in the market to influence the price.
• Investors have unlimited access to borrow (and lend) money at the risk free rate.
In creating models, Markowitz needed to make certain assumptions about markets, but how many of these assumptions make sense? One particularly snobby and snarky individual insisted that if I knew chaos theory better, these assumptions would make more sense. I politely disagree.
A key component of MPT is diversifying investments or having investments with varying (and preferably) low correlations with one another. A correlation of 1 would mean the two investments have a 100% correlation and move in tandem while a correlation of -1 would be the antithesis. If all the asset pairs have correlations of 0—they are perfectly uncorrelated. Correlations don’t measure magnitude and 2 investments can have a high correlation with varying betas. To avoid going down a rabbit hole, we’ll leave this concept and move on.
If you recall the financial crisis, almost all asset classes went down in tandem (except US treasury bonds and gold) in 2008. There’s a variety of reasons why this happened, but let’s focus on correlations. Correlations in the stock market in the US and globally increased dramatically and I’d argue the preponderance of easily traded ETF’s made it even easier to sell. Since 2008, the number of ETF’s has exploded and there are an incredible amount of ETF’s that seemingly trade anything (except Bitcoin, for now). The ability to click a button and sell is way too easy which is why in times of stress, correlations increase. The MPT assumption of investors being rationale is somewhat laughable during a crisis.
I believe the purpose of MPT is to increase returns and reduce risk by diversifying amongst uncorrelated investments. If international and US stocks are now more correlated than in the past, owning both doesn’t provide the same level of diversification it once did. So how do you find uncorrelated investments?
Asset Allocation in Today’s Era
In today’s era, I believe diversifying by strategy type as well as asset class type is critical. That means investing in passive and active strategies, trend following approaches, alternative investments, startups, real estate, etc. Our main stock approach for clients is a trend following program I created that provides a risk managed approach to owning stocks. This strategy ends up looking very different than the S&P during past financial crises like 2000 and 2008.
Alternative investments has been increasing in weighting in client portfolios this year and I expect this trend to continue. These strategies have very low correlation with the stock market and with each other and range from construction loans, middle market lending, global macro hedge funds, private equity, long/short credit and so on. Individuals appear to be adopting alternative investments in greater amounts and are attempting to follow the endowment model. If you look at investment allocations for endowments, they tend to have alternative investment allocations of over 30%. These alternative investments tend to have higher minimums (the best of breed managers can have $10 million minimums), but we’re able to access them via our relationships for relatively low minimums (in most cases). Furthermore, no 2 clients of mine have the same allocation. Since I take the time to understand my client’s needs, risk tolerance and goals, I can structure their portfolio in ways most other firms can’t or don’t.
If you’re interested in starting a dialogue and learning how I can help, please click the link below to book a call or meeting.
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