The typical approach to spreading one’s assets in order to diversify and conquer, is to have the client complete a risk tolerance questionnaire. That survey is important not only to establish guidelines for how the assets will be managed, but also because some form of it is required by securities regulators to make sure advisors know who their clients are. The magical conclusion usually includes a color pie chart, representing a variety of asset classes that are assumed to be a path toward asset growth and preservation of capital. But is that pie chart really no more helpful to the client than getting a pie thrown in their face like an old slapstick comedy?

From our experience, there are two common shortcomings with the now-commoditized approach to gauging an investor’s emotional makeup: reliance on so-called “Modern Portfolio Theory” (MPT) and the tired mantra of “Diversification”

The folly of “optimal” portfolios is based on MPT. The concept is sold based on stories about Nobel-prize winning theories and successful results during the last century. For MPT to function, one must estimate future returns on different types of investments. Often, this is done by assuming that future returns will mimic those of the past century, half-century or perhaps a shorter time period. But to me, there has never been a time in which future returns are less likely to reflect those of the past. Why? Stocks are at record levels and still have not wrung out all of the excesses of the 1980′s / 1990′s bull market. And bonds? Interest rates have been falling for over 30 years, generally speaking. That fact alone screws up any attempt to estimate the future based on the past. Bond returns are very hard-pressed to come close to what they have earned since the mid-1980′s. The math just does not work. And cash returns, currently near zero, also do not come near what many MPT return estimates have. From here forward, the past is not useless, but it is far from useful. Massive “QE” from central banks only muddies the picture further. To me, while MPT has worked pretty well through the more bullish markets of our lifetime, too many people are failing to see that a part of that machine is broken and it makes MPT a dangerous thing when used blindly.

Given where markets are today, simply accepting MPT as what it has been in the past smacks of marketing departments of major Wall Street firms devising shortcuts for financial advisors, in the interest of creating size and scale for their business. But is this the best thing for the client? And just because you own 17 different types of assets, what’s to stop most or all of them from running in the same downward direction when global markets get thrashed…which, by the way, is the time when you really need diversification to work!

The markets of yesteryear seem like a lifetime ago. Technology and globally intertwined markets have changed things. This calls for a different approach, one built for the 21st Century. Here is how I think it should work in the discussion between the investor and their advisor:

  • Ask more relevant questions upfront – find out what makes the investor happy or unhappy about the movement of their portfolio’s value?

  • Carefully analyze, qualitatively and quantitatively, what the client wants

  • Construct a portfolio that combines a core group of individual stocks, supplemented by ETFs and/or mutual funds

  • The goal here is to better target client goals, and avoid a condition known as “de-worsification” – where you think you are getting the benefits of diversification, but you are not.

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