Modern Portfolio Theory: There’s a Better Way

Modern Portfolio Theory. It sounds so academic, so sophisticated, so modern. But in the year of its 70th anniversary, might the word “modern” be a little outdated?

It’s no secret that at NEST, we believe that to be true. We’ve said it before — using Modern Portfolio Theory to manage client investments is the lazy way of doing things.

But why would we be so bold as to make that claim? After all, many firms and investment managers still use it to manage their clients’ portfolios today. Modern Portfolio Theory can’t be all that bad if so many people use it, right?

To understand why we take a different approach at NEST, we first need to understand what Modern Portfolio Theory is.

 

What is Modern Portfolio Theory?

If you’re exploring an unfamiliar city, is it better to have an inaccurate map, or no map at all?

This is a question Nassim Taleb raised in his book The Black Swan: The Impact of the Highly Improbable. In this analogy, the inaccurate map that many investors use to determine the best asset mix of a portfolio is called Modern Portfolio Theory. Having no map at all, represents the crapshoot that came before it.

Some would argue that an inaccurate map is better than none at all, and they’ve made enough money using this strategy to back up this claim.

In 1952, Harry Markowitz, wrote his dissertation, “Portfolio Selection,” in which he created Modern Portfolio Theory. In 1990, this work earned him the Nobel Prize in Economics.

The essence is this: rather than focusing on the risk of each individual stock, currency, or other asset, Markowitz showed that by diversifying a portfolio, you get less volatility overall than the sum of its component parts.

Put simply: each asset could be pretty volatile, but put together in a portfolio, the overall volatility can be very low.

The key to it all is diversification. Investments that have high returns also tend to have high risk, and vice versa. Because of that, Markowitz said that by creating an optimal mix of high and low risk assets based on the individual’s risk tolerance, a portfolio could achieve its best results. 

In short, for a given level of risk, according to Modern Portfolio Theory, there’s an optimal portfolio mix. That means a combination of stocks, bonds, and other asset classes in different ratios.

This theory is still the bedrock of modern finance, and many financial advisors rely on it to manage client portfolios to this day. 

 

Before Modern Portfolio Theory

If trying to grasp the vagaries of the market, making decisions on what assets to buy or sell and in what class seems, well, complicated, working in investing before the 1950s was probably not for you. 

The olden days of investing was a game of prediction — which stocks to buy and sell, and when, making it more akin to a casino than the trading we know today.

Then along came Markowitz’s Modern Portfolio Theory, which mitigated overall risk, offered investors a formulaic strategy, and made it easier in general.

All you have to do is assess your client’s risk tolerance then stick them into a prefab portfolio that fits with their risk comfortability. You don’t have to think too much about what the market is doing or the state of the economy in the U.S. or globally, because your clients are in for the long haul. Just keep your models’ ratios in order. This allows investment managers to handle a lot more client portfolios because it reduces the amount of actual work they need to do to maintain them.

This system is obviously a lot more efficient than the old wall street guessing game. No wonder investors glommed on and refused to let go, even as the world, economies, and availability of information and technology continued to change at breakneck speed.

 

So, what’s wrong with it?

Let’s return to the map analogy. Why should investors have to choose between having an inaccurate map or no map at all as they navigate the ever-changing world of finance? Especially when you can use GPS!

Few would argue with the fact that the world today looks a lot different than it did 70 years ago when Markowitz first published his dissertation. 

You could navigate with some success using a 70-year-old map, but it certainly wouldn’t be the most efficient way. 

The technology, connectivity, and the amount of by-the-minute information available to us would send even Markowitz’s head spinning.

So why would we use a system of portfolio management that was literally devised for another era?

We’ve called Modern Portfolio Theory lazy because it’s formulaic. An investment manager can assess your risk tolerance, input your information into their software, and then stick you into the model the software spits out. They’ll check in on it bi-annually, once a quarter if you’re lucky. 

But that’s it. 

You’re expected to play the long game, and your investment manager can essentially keep your asset ratios in order, and otherwise forget it.

 

NEST’s alternative to Modern Portfolio Theory

While Modern Portfolio Theory stresses allocation ratios, at NEST we use data.

Of course a lot of people have made a lot of money using the diversification and asset allocation system. But we’d argue that in a world of more complex economies and more data, that’s not the best way. There are ways to avoid losses which can prove to be major setbacks for achieving your financial goals. There are also ways to grow assets more efficiently and optimally in any economic environment. 

We’ve talked about Sean’s process and our data-driven, macro-economic strategy in another blog post, but the gist is this: we don’t need to follow a formula that’s a relic from another time. Just like we don’t need to use an inaccurate road atlas from 70 years ago. We have Google Maps. And when it comes to our clients’ portfolios, we’re going to use diversified asset classes coupled with by-the-minute economic data to actively manage investments and get us all to our destination in record time.

 

Sean’s Process

For those using NEST’s investment management services, we start with a risk tolerance assessment, similar to firms who use Modern Portfolio Theory. We also find which of our portfolios work best for you, choosing between SUSTAIN, BOOST, AUGMENT, ESCALATE, and OPTIMIZE. 

For many firms, reaching this point means their work is done until your review six months later. At NEST, our work is just beginning. 

Each day, Sean spends hours researching and analyzing worldwide economic data from credible, unbiased sources. He uses this information to make daily and weekly tweaks to each of NEST’s portfolios. Then, he reads the economic environment and anticipates changes to come based on the data. Only then does he move assets based on that macroeconomic information. 

There are no ratios to maintain as in Modern Portfolio Theory. There is no holding on to asset classes, trusting that in the long game, the general trend will move upward. 

Sean’s process is well-informed, data-driven, strategic, and responsive.

We leave the formulaic approach to the other firms.

 

Are you ready to take a modern, data-driven approach to your investments? Why not schedule a no-obligation call with NEST. We are an Austin based, boutique firm that is passionate about offering optimized and personalized investment strategies to Austin and Hill Country individuals, business-owners, families, and entrepreneurs. Let’s move beyond theory together, and get you to your destination.

 

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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.