Every once in a while, I will read an article that gets my mind spinning to the point that I cannot shut it off and I feel the need to share it with all of my wonderful readers.
Jonathan Justice (cool name), has written an article for Wealth Management titled, “Not-So-Modern Portfolio Theory”, and it really got me thinking. In this week’s newsletter, I’m going to include some excerpts from this article and my thoughts from a Safe-Money perspective.
Jonathan’s thoughts will be in black italics, and I will include my thoughts in blue. I hope you find it helpful!
In 1992, I remember thinking: compact discs are here to stay. They sound great; they’re more durable than records, 8-tracks or cassette tapes, and they’re vastly easier to store and carry around. With CDs, we could skip and repeat tracks easily, and when multidisc players became the norm, the music never stopped. The real beauty of the CD, though, was its medium—a beautiful, binary code that could store a huge amount of data, a whopping 700 megabytes of the highest quality recordings we had ever heard.
Tragically, the very essence of the CD was the thing that led to its downfall: the invention of digital music. As innovators quickly learned, digitization lent itself easily to transference and conversion, and ta-da! The MP3 was born, and CDs went the way of the dinosaurs.
Modern Portfolio Theory has suffered a similar fate: what began as a groundbreaking tool for investors has fallen prey to the subsequent innovations born out of the original theory. The key tenets of the theory are “diversification” and “correlation”—a well-diversified portfolio constructed of lowly-correlated assets will provide higher returns without a commensurate amount of risk. While the basic tenets of MPT hold true, its present-day application often results in the construction of over-complicated and needlessly over-diversified portfolios.
In 1952, when economist Harry Markowitz first wrote about Modern Portfolio Theory, the investing world was a different place: only 4% of Americans owned stocks.
By contrast, today nearly 60% of Americans own stocks, marketable Treasury debt is over $23 trillion, and investors have over 125,000 mutual funds and 7,600 exchange-traded funds from which to choose.
Jonathan’s remarks about CDs and how fast we transitioned to streaming music is a reminder of, not only how fast things can change, but once a new technology hits critical mass the other technology dies quickly.
It was the same with VHS & DVD’s- not too long ago we had entire stores to shop for and rent movies on these mediums, and today, I do not even own a DVD player, much less have an entire store to go rent a DVD. Everything is streaming now.
My point? Modern Portfolio Theory (MPT) was first conceived in 1952. How many of you still use a TV, a radio, a car, a refrigerator, or medical therapies from 1952? I will say that things were built to last in 1952, but very few consumer products, medical therapies, or ways of life, in general, are even close to being the same as they were 70 years ago.
I mean, just look at the difference in the number of people who own stocks compared to 1952, and the number of investment choices (over 125,000 mutual funds) available. It’s overwhelming!
At the birth of MPT, diversification was a narrow concept given the relatively limited investment options available to the public, comprising primarily large-cap domestic stocks, government bonds, and corporate bonds (and mutual funds that held stocks and bonds). While stock-bond correlations have swung broadly throughout history from negative to positive, the degree of risk-return variance—has largely been more reliable: stocks are riskier and have a higher standard deviation; bonds are less risky and have a lower standard deviation. Markowitz’s objective of achieving “lower volatility” hinged on the optimal combination of these risky and less-risky assets working in tandem.
We live in a very different world than in 1952. Around 1998, computer-generated trading began and caused extreme volatility in our equities markets. Combine that volatility with a low-interest-rate environment in the bond market, and MPT is likened to trying to plug your iPad in the back of an RCA TV to stream a Netflix movie – maybe you’ll be able to get it to work, but not very well.
Over the last several decades, as the investment advisory industry adopted prudent investor standards that demanded “diversification,” and as access increased to a myriad of investment vehicles, portfolios have come to resemble less and less how a “modern portfolio” may have looked in 1952. Instead, today’s portfolio has become a “chiclet chart:” an account that holds not only broad asset classes but also every flavor and color of sub-asset class in addition to vehicles that provide access to real assets such as commodities, real estate and gold.
Again, 125,000 mutual funds and 7,600 ETF’s to choose from. How do you know which ones are the right ones? Sometimes, less is more. Have you ever eaten at The Cheesecake Factory? I hate that place. It takes an hour to get through the menu and then I still cannot decide what to eat, so I just pick out of exhaustion.
Now, put that same perspective on your financial future and how do you feel? Is it a good idea to randomly pick an investment out of exhaustion that is responsible for providing retirement income for the rest of your life?
The principal conclusion from these observations is that today’s staggering array of investment options provides a false sense of meaningful diversification. Beyond correlations, investors will also find that among broad asset classes, sub-asset classes typically offer a narrow range of risk exposure (i.e. standard deviation).
True diversification means to have something that represents an unlikeness of something else. In the world of finance, your money is either safe from loss, or it’s not. It’s really that cut and dry.
MPT does not represent true diversification of your assets if they are in financial sectors and products that can sustain a loss. All MPT is representing is different degrees of loss that you can sustain, but your money is still at risk.
True diversification would mean that you have part of your money at risk, and another part completely risk-free.
Tom Hegna has a great line that I wish I would have thought of: “An Income Annuity functions like a AAA Rated Bond with a CCC Rated Yield, and zero standard deviation.”
I mean, that is brilliant!
Today’s truly modern investor would be best served by segregating accounts by purpose and allocating to those accounts the asset classes whose return and risk characteristics reflect the respective objectives. An MPT-driven portfolio may be most appropriate for investors seeking some combination of lower volatility, current income and long-term appreciation in a single account. That said and regardless of the objective of a specific portfolio, selecting high-quality securities within the chosen asset classes will position investors to retain the potential for outperformance while reducing the needless complications of an over-diversified, beta-yielding portfolio.
There’s a lot to unpack in this last paragraph:
Justice states to “segregate accounts by purpose”. I couldn’t agree more! Those of you who have spoken with me or have watched my video series know that I ask about the purpose of your money. Is it for income, growth, or legacy? If it’s for income, then it should be guaranteed lifetime income. Nothing can provide that except for Social Security, a pension, and an income annuity.
Justice states that “An MPT-driven portfolio may be most appropriate for investors seeking some combination of lower volatility, current income and long-term appreciation in a single account.”
Okay, the very nature of that statement is paradoxical. When you assign a purpose to every single dollar that you have, you should want to put it in the most effective area possible. Otherwise, part of the portfolio will act as an anchor and stunt the purpose of the other part.
Would it be a ridiculous idea to have a portfolio that is part guaranteed income or protected from loss with gains, and the other part designed just for growth with market speculation?
Is it crazy to think that a portfolio like that would give you the best results in both areas?
Justice states, “selecting high-quality securities within the chosen asset classes will position investors to retain the potential for outperformance while reducing the needless complications of an over-diversified, beta-yielding portfolio.”
Who is going to select them? Do you want to shoulder that responsibility?
Would you be against knowing exactly what you are going to get and exactly how long it will last you?
I personally don’t think you would and that’s why I started Atlas Financial Strategies, Inc. I wanted to own a company that could tell people in plain English what they could expect and what they could count on throughout their retirement.
You see, 30-40 years ago there wasn’t a need for guys like me because almost everyone had defined-benefit pensions. Between Social Security, your pension, some whole life insurance, and a handful of blue-chip stocks, that was all you needed to make sure you always had money/income.
Over the past few decades, it has gotten drastically more complicated and financially dangerous. If I could somehow wave a magic wand and help you to see that your retirement is no longer about chasing returns, but instead about securing income to avoid longevity risk, I certainly would. But unfortunately, I cannot.
What I can do, however, is encourage you to find out how you can secure a guaranteed income. And secure a greater amount than you would be able to using the other outdated retirement strategy, such as the “4% Rule.”
In my video series, which can be viewed at the bottom of this page, I will give you my exact strategy of how to get 20% more spendable income in your retirement. I have broken it into 5 separate short videos to view at your convenience.
Once you have had a chance to watch it, please don’t hesitate to reach out to me directly at 636.926.6500, or book a short phone call by clicking on the “Schedule a Call” button in the top right corner of this webpage.
Thank you for reading and I hope you are having a wonderful summer so far!
All the best,
Marty