Why modern portfolio theory is a defective way to build out an investment portfolio. This episode explains a better approach to asset allocation.
In this episode you’ll learn:
- What are the inputs needed to compile an asset allocation using modern portfolio theory.
- What are the defects with modern portfolio theory.
- Why we should be minimizing our maximum regret rather than maximizing our returns.
- A more flexible approach to asset allocation that isn’t reliant on modern portfolio theory
Modern portfolio theory (“MPT) has been the primary school of thought in global investing since the 1950s. On this episode of Money For the Rest of Us, David explains why he doesn’t consider this theory to be the best guiding factor while investing. He outlines a few major concerns that thought leaders have uncovered and provides insights into other ways of thinking about your portfolio. It’s an educational episode that you don’t want to miss out on.
What is modern portfolio theory, and what does it seek to provide?
Developed by Nobel Prize winner Harry Markowitz, modern portfolio theory is a way of allocating assets in such a way that maximizes your returns while estimating various levels of volatility, risk, correlating trends, etc. It’s often used by financial advisors to recommend portfolios to clients.
There are many downfalls to relying on this school of thought when investing
While modern portfolio theory looks great on paper, it becomes more challenging when put into practice. David explains a few major points of concern that have been raised since the theory’s inception. They include:
- The dangers of making up data in order to model less liquid asset classes such as venture capital using modern portfolio theory
- Higher risk levels for “extreme events” in real life than within MPT based portfolios
- The dangers of expecting average positive outcomes vs. the worst possible outcomes
The true goal of investing should be about “minimizing your maximum regret in the meta-game”
When examining the pros and cons of modern portfolio theory, David uncovered some great insights from writer Ben Hunt, Chief Investment Officer for Second Foundation. Hunt explains, “My goal as an investor is not to maximize my investment returns or to maximize my personal wealth. My goal as an investor is to minimize my maximum regret in the meta-game.” The meta-game is your entire lifetime of investing. It’s looking at the forest vs. the individual trees – the garden vs. single plants.
Hunt continues, “Minimizing the risk of that is what drives my doing, in both politics and in markets. I want enough wealth to avoid the bad ending, not the most wealth I can possibly achieve, because going for the most wealth I can possibly achieve actually increases the chance of a bad ending.” For even more great insights into minimizing risk while achieving reasonable amounts of investment success, don’t miss this episode.
Just as in life, there is never “the best answer” to building a portfolio
Perhaps the biggest theme that investors come to realize after moving away from modern portfolio theory is that there is no single “right way” to invest. Extreme events happen, portfolios shift, and financial markets are complex systems filled with unexpected variables. David encourages his listeners to understand that we each have to invest in such a way that makes us aware of the variables and extremes, but still allows us to have a chance of receiving reasonably successful rewards. Investors make the best decisions they can based off of the current information, and it often comes down to being a waiting game. Finally, David says, “Instead of maximizing and trying to maximize, let’s just step back and start where we are, use what we have, do what we can, just do it little by little.”
- [0:11] What is modern portfolio theory?
- [4:29] There are many downfalls to relying on this theory while investing
- [7:05] We should prepare for the worst possible outcome when investing, not the average positive outcome
- [14:08] The true goal of investing should be about “minimizing your maximum regret in the meta-game”
- [18:34] There isn’t the best “right answer” with your portfolio
- [25:15] Maximization of anything doesn’t work in today’s environment