Investment Philosophy

The majority of financial advice today is based on MPT (Modern Portfolio Theory), the result of the work of Harry Markowitz (1952-1959). MPT proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line.

The most common application of MPT is strategic asset allocation, a static selection and diversification of asset classes by the style box below. This is typically a buy and hold strategy, comprising stocks, bonds and cash.

MPT is put to the test in the bear market from Oct 2007 - Mar 2009. This theory from the 1950's may not be keeping up with the rapid changes in the financial world. Traditional diversification did not prevent losses as large as what we have witnessed. Losses approached 60% for the major indexes.

It may be time for a fresh approach: we adapt the application of Modern Portfolio Theory to today's investment environment; one that consists of more than stocks, bonds & cash.

The past 50 years, especially after the birth of the internet, have produced accelerating changes in areas like market globalization, alternative financial instruments and sophisticated risk-management techniques.  Combine these developments with extraordinary technological developments and even the 'average' investor may now be able to apply sophisticated investment strategies to their own portfolios.

These sophisticated investment strategies have been used and validated by large institutions and institutional investors for years.  Knowing of and understanding that such sophisticated investment strategies exist is one thing; implementation is entirely different. 

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Expanded Diversification

(Please note that diversification does not guarantee against market losses. It is a method used to help manage investment risk.)

The essence of diversification is to incorporate non-correlating assets; investments that don't react the same relative to each other.  Attempting to better diversify by adding non-correlating investments; investors have traditionally integrated international stocks into their portolios.  However, as the global economy becomes increasingly integrated, the correlation of domestic & foreign investments (see below) becomes more closely tied making it more difficult to use together for purposes of diversification.  As such, a traditionally allocated portfolio does not offer the potential of downside protection it once did.

Expanded diversification today would include non-traditional asset classes and hedge-fund like techniques - eg. calls and puts, long/short/inverse/1.5X, 2X, 3X funds, sector funds, ETFs, etc. Besides the traditional strategic (static) asset allocation, new active allocation models like tactical asset allocation, dynamic asset allocation, core/satellite asset allocation, complementary genius asset allocation, etc, have emerged.

As research catches up with a changing real world, new theories will emerge in future. In the meantime, investors have to decide if they can afford to entrust their nest eggs to MPT, or monitor their portfolios more closely by adapting and building on MPT. My professional opinion leans towards the latter - there is no replacing an "active pilot" to bring the ship in through potentially volatile times ahead.

Call 970-6722111 or email Henry Ho at henryho@financialstewardsllc.com to discuss further, how you can be better served. 

Graphic used with permission from Alpha|Source Investment Councel; a WE2 Company.  www.AlphaSourcePortfolio.com.

 David Swensen grew the Yale endowment fund to over $18 billion in 2006 from $1.3 billion in 1985; an annualized return of 16.3%.  Today, just 16% of the endowment is committed to US stocks & bonds...84% isn't.

Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements.  Investors should consider the special risks with alternative investments including limited liquidity, tax considerations, increased expenses, potentially speculative investment strategies, such as leverage and commodity price volatility and different regulatory and reporting requirements.