Why we need distinct risk buckets: balancing our natural loss aversion with the allure of opportunities that offer the potential for massive upside.
Topics covered include:
- What is modern portfolio theory, and what are some of its flaws
- Why so many people have gotten wealthy by being undiversified
- How to balance personal risk, market risk, and aspirational risk
- How prospect theory explains our attraction to positively skewed opportunities
- Why most people won’t get wealthy unless they take some aspirational risk
Show Notes
Average, Median, Top 1%, and all United States Net Worth Percentiles—DQYDJ
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein, and today is episode 496. It’s titled, “Are You Taking Enough Aspirational Risk?”
Modern Portfolio Theory
In 1952 Harry Markowitz of the RAND Corporation published a paper titled “Portfolio Selection”, in the Journal of Finance. The paper introduced what came to be known as Modern Portfolio Theory. Markowitz eventually garnered a Nobel Prize for his work on portfolio construction.
Modern Portfolio Theory, or MPT, is a method for constructing optimally diversified portfolios that maximize the expected return for a given level of risk. Risk in MPT is measured by volatility, specifically standard deviation. How much does a given asset or portfolio deviate from the expected return?
In order to construct a portfolio using MPT—and I did this for years as an institutional investment advisor—we need an expected return for each asset class, we need an expected volatility, as measured by standard deviation, and we need a level of correlation between the asset types.
To what extent do the different asset classes’ returns track each other? Do they go up and down by the same amount, or do they move in opposite directions? The optimal portfolio derived from MPT will fall along a risk-return line, which is known as the efficient frontier. What the model does is it will generate a series of portfolios with certain weights in each of the different asset classes.
It could be large-cap stocks, small-cap stocks, bonds. Any asset class can be included as long as we come up with an expect return, a volatility, and a correlation. And so the model generates these portfolios, and the optimal ones lie along this risk-return line called the efficient frontier.
As an institutional advisor, I would run these studies, I would meet with an endowment investment committee, we would talk about the different portfolio options, and look at what the weights were in the different asset classes. Here’s what I found. Clients didn’t want an efficiently optimal portfolio.
They wanted a portfolio that was palatable. They didn’t necessarily want what the model spit out. They might not want 30% in small-cap stocks if that’s what the model said, which is why back in the office we would come up with constraints for different asset types. No more than 15% in small-cap stocks, for example.
We would essentially build a portfolio using those constraints, using the assumptions, in order to come up with portfolio options that we knew the committee would find acceptable, that were similar to what their peer universities were doing. It was sort of like providing an optimal diet for clients using only the food groups and the amounts that they’re willing to eat.
What I learned is that, yeah, we can use MPT to build diversified portfolios, but there’s a human element to portfolio construction. It’s super-difficult just to optimize it because of this human element.
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