Modern Portfolio Theory – Part Two

This article is part of a series; click here to read Part One.

Efficient frontier diagrams do not actually show the asset allocations of portfolios on the efficient frontier, but this information is also available. Exhibit 1.3 provides an example of ten portfolios on the efficient frontier shown in Exhibit 1.2. These range from the lowest return and volatility combinations to the highest return and volatility combinations. For example, portfolio one is listed with a 3.8 percent return and 3 percent volatility. This portfolio consists of a 91.3 percent allocation to Treasury bills along with small allocations to corporate bonds (7 percent), small-cap stocks (1.3 percent), and large-cap stocks (0.4 percent). Despite small-cap stocks being the most volatile asset class choice, the low correlation of characteristics it shares with other asset classes helps it to play a small role in a low volatility portfolio. The overall portfolio volatility of 3 percent is slightly less than the 3.1 percent volatility of Treasury bills on their own. Then, as we move down the list, we find portfolios with increasing returns and volatilities that contain increasing allocations to stocks and a gradual phase out for Treasury bills and other bonds. The fifth portfolio is the most diversified with an allocation to five of the six asset classes. It provides overall returns of 9.3 percent with a volatility of 11.2 percent.

Exhibit 1.3 A Selection of Outcomes from the Efficient Frontier as Based on US Financial Market Nominal Annual Returns, 1926–2018

Source: Own
calculations from SBBI Yearbook data
provided by Morningstar and Ibbotson
Associates.

We now understand that there are serious issues with using MPT to determine
investment portfolios for household investors, especially after retirement
begins. Harry Markowitz recognized this. After winning the Nobel Prize in 1990,
he was asked to write an article in 1991 for the first issue of Financial Services Review about how MPT
applies to household investors. This article was named, “Individual versus
Institutional Investing.” In the article, he writes about how he had never
thought about the household’s investing problem before, and after reflecting on
it for an evening, he realized that households face a very different investing
problem from the large institutional investors, such as mutual funds, he had in
mind when developing MPT. MPT does not teach how individual households should
build investment strategies to meet their lifetime financial planning goals.

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Namely, and this is really the key for understanding how the retirement
income problem differs from the MPT approach, households must meet spending
goals over an unknown length of time in retirement. MPT just seeks how to grow
wealth over a single time period, such as a year, when there is no need to take
distributions from the portfolio. It is an assets-only model. The preretirement
wealth accumulation notion that households seek to grow wealth is more closely
aligned with MPT, but the retirement income problem is vastly different. There
may surely be a relationship between the idea that having more wealth will
support more spending, and the idea that building diversified portfolios is
still valid, but that relationship is more complicated when it is unknown how long
the spending must last and when taking distributions from assets works to
amplify the impacts of investment volatility on the retirement income plan.

With sequence risk for portfolio distributions, the extra shares sold to
meet a spending goal when markets are down are no longer available to
experience the growth of any subsequent market recovery. The point chosen on
the efficient frontier can be different when viewed in the context of the
household’s problem, and there can be a role for annuities or other risk
management tools that are not included as asset classes in traditional MPT.
Simply, MPT does not account for cash flows or longevity risk. It equates risk
with short-term asset volatility rather than with the ability to meet financial
goals.

Risk in the context of the household’s investing problem is only
tangentially related to the volatility or standard deviation of returns.
Volatility is important in that it relates to risk tolerance and whether
individuals can handle the short-term volatility of their portfolio. If greater
volatility leads them to not stick with their financial plan, then this must be
incorporated into the asset allocation decision. But more generally, risk for
the household relates to the ability to meet financial goals over a long-term
planning horizon.

A low-volatility portfolio offering insufficient return potential can
ensure failure for the financial plan. This is riskier from the household’s
perspective than a more volatile portfolio that supports a higher probability
of success for the financial plan. A key difference between probability-based
and safety-first approaches is that the probability-based approach is more
comfortable with accepting greater volatility for higher return potential and
an improved chance for success, while the safety-first approach looks for
alternatives that do not expose core retirement spending goals to market
volatility. The question is ultimately about which is the best way to be able
to spend more than a bond ladder can support: to rely on the excess returns
expected to be provided by the stock market, or to rely on the power of risk
pooling to bring additional spending power to those facing a higher cost
retirement.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

 


Originally posted at https://retirementresearcher.com/modern-portfolio-theory-part-two/

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