The retail investment industry has spent decades reeducating and redirecting the masses – away from stock and bond trading to asset allocation-based asset management. One reason is self-preservation. Trading is transactional and commoditized. The emergence of discount brokerages initiated a race to the bottom for trading commissions. The other reason, the one I will address, is the application of modern portfolio theory.
Modern portfolio theory is rooted in the 1952 published work of Nobel Laureate Dr. Harry Markowitz. Markowitz applied mathematical statistics to investment portfolio management to demonstrate the benefits of a diversified portfolio over individual stock selection. By combining investment assets with different risk/reward profiles, one can improve a portfolio’s overall efficiency: greatest return per level of risk or, stated another way, least risk per level of return. Yada, yada, yada.
Stocks Fall, Bonds Rise and Vice-Versa
It took many years, but Wall Street finally came around. (The appeal of asset-based management fees over transactional commissions certainly helped.) Nowadays it is the norm for financial advisors, aka investment advisors, financial planners, wealth managers, etc., to offer asset-allocation-based investment solutions. Who has not seen an asset allocation pie chart on their account statement or performance report?
Despite its benefits, modern portfolio theory is not foolproof. One of the biggest limitations is that its analysis is backward-looking. Wall Street firms “optimize” portfolios using historical data. Recall this famous disclaimer: “Past performance is not indicative of future results”? These approaches fail to consider current market conditions. For example, if one asset class, say stocks, is grossly expensive compared to another, say bonds, wouldn’t it make sense to reduce the allocation to stocks in favor of bonds in a balanced portfolio? Nevertheless, practitioners routinely place their clients into “cookie-cutter” asset-allocation models without regard to the present, much less, near-term outlook.
Another limitation is the lack of true diversification offered by just stocks and bonds. Historically, over the long run, stocks and bonds have exhibited positively correlated performance, meaning that they tend to move in the same direction. However, for the past two decades, investors have witnessed a stock-bond correlation that is consistently negative (stocks fall, bonds rise and vice-versa) until last year. 2022 served as a wake-up call as both stocks and bonds sold off hard.
You can too
Enter “Alts.” Alternative investments can be loosely defined as anything that does not fit within the stock and bond categories. It can include alternative assets, such as real estate or precious metals, or alternative investment strategies, such as “hedge funds.” Studies done by AQR Capital Management and others have shown that the inclusion of a third asset class can further improve a portfolio’s efficiency, as well as providing another source of return. Institutional investors have long known this and applied it to their portfolio management. You can too.
About the Author
Bill McCollum is an investment advisor representative with Eagle Financial, a Wealthcare company. Investment advice offered through Wealthcare Advisory Partners, LLC, (“WCAP”). WCAP is a Registered Investment Advisor with the U.S. Securities and Exchange Commission. Investing involves risk, including potential loss of principal involved. Past performance is not a reliable indicator of future results. Not all strategies are suitable for all investors.