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Is Your Portfolio Up With The Times?

3/13/2018 2:29:50 PM by Morgan Wendlandt Edited for David Gaylor Leave a Comment
I had someone come into my office the other day, let’s call him Gary. Gary's a good hardworking guy, about 58, and from Shelby County. Gary told me he is pretty happy with his current advisor and financial strategy, which is based wholly on the Modern Portfolio Theory. There's that word again, "modern" it gives people the impression that something is new and updated. So when you hear Modern Portfolio Theory, you probably think it is a new, updated financial philosophy, designed for the current times. But despite its name, the Modern Portfolio Theory has been around for a long time.

The Modern Portfolio Theory (MPT) was created by Harry Markowitz back in 1952 and often is the "go-to" strategy for many retail advisors and do-it-yourself investors. It is an investment theory based on maximizing expected returns based on a given level of risk. MPT was designed for risk-averse investors, and Mr. Markowitz was one of the first to quantify the benefits of investing in multiple, uncorrelated stocks, rather than investing in an individual stock. He theorized that investors, who generally want to take on as little risk as possible in order to achieve a certain return, can limit their risk with diversification.

Sounds complicated, right? Let me explain. Let's say you invest in two different stocks: one stock in a company that sells coffee and another in a company that sells irrigation systems in South America. If there is a drought that hits all of the coffee bean farms in South America, the coffee company might struggle but the irrigation company will thrive. On the other hand, if there is plenty of rain and the coffee bean crop is strong, the value of the coffee company will rise, while the irrigation company might become stagnant. You are essentially hedging your bets, so that, rain or shine, your portfolio won’t take a nosedive.

All of this makes sense and is a valuable concept for a portfolio even today but there are some finer points to this theory that every investor should understand.

I explained to Gary that his portfolio, which is based on MPT, is allocated to different asset classes—let's say 60 percent in equities and 40 percent in bonds—for a specific period of time. The idea is that with those designated allocations, an investor should receive his or her expected results at the end of that time frame—let's say eight years. I also told Gary that I don't look at any strategy as good or bad; I look at each strategy as appropriate or inappropriate based upon knowing the right questions to ask, so he can determine whether or not his MPT-based strategy best serves his investment needs.

Questions such as, "What if market conditions change?" Market conditions are always changing for many reasons: demographics, global political issues and central bank policies, to name a few. As a result, a portfolio allocated a specific way in 2018 may have a very different level of risk for that same allocation in 2020.

Another question is, "What happens if a certain sector of the market is booming and the other sectors of the market are lagging; wouldn't we want to overweight the sectors that are performing and scrap the ones that are not?" "Wouldn't we want to rotate assets into sectors that have a higher probability of success based upon changing market conditions and rotate out of ones that are less favorable?"

I then asked Gary about his rebalancing strategy? By the look I saw in his eyes, he does not have one. Investopedia explains rebalancing in a very simple way: "the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation." MPT doesn't account for changing risk in the market and when that portfolio should be rebalanced.

With Gary's portfolio, if he was initially allocated 60 percent in stocks and 40 percent bonds, and the stocks performed well over a specific time period, that would put a greater percentage of his money in stocks, perhaps throwing off the balance to 75 percent and 25 percent. In order to return to his desired weighting, Gary would sell some of his stocks and buy bonds. This would get him back to the 60/40 he was comfortable with.

But let's say the stock market is incredibly strong for the next eight years and he does not have a system in place to rebalance his portfolio. When Gary is 65, he might have 75 percent of his total assets in stocks. He unintentionally has a much higher risk than initially intended. Then let's say in that ninth year (just before Gary is about to retire), the market tanks. Under this scenario, 75 percent of his portfolio would be at risk, and he could lose half of that. How modern is that? Essentially, Gary and his advisor have created a "set it and forget it" portfolio based upon MPT.

To put it plainly, Gary's strategy, is not modern, and certainly is not vigilant or very alert. Don't you deserve better?

This content created by David Gaylor in conjunction with Fusion Capital Management.

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The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by radical promoting and their editorial staff based on the original articles written by jeff cutter in the falmouth enterprise. This article has been rewritten for David Gaylorand the readers of David's Family Finance. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.