Your Investments Are In The Risk Under Modern Portfolio Theory
Even though there are countless financial advisors and professional investors around the globe, it may surprise you to learn that the vast majority of them march in lockstep to the same theory.
This doesn’t mean they always make the same decisions, but that’s a testament to how weak this concept is. Nonetheless, if your money is being managed by someone else, Modern Portfolio Theory is probably being used to guide it and that could be a huge mistake.
What Is Modern Portfolio Theory?
First, let’s begin with the basics. Modern Portfolio Theory (MPT) is based on the belief that there is a predictable and measurable relationship between different types of assets (e.g., bonds, stocks, commodities, etc.).
Therefore, there should also be a specific blend of investments that leaves you with the maximum amount of return for a specific amount of risk.
Furthermore, any asset class that involves more risk than what you’d have to put up with from U.S. Treasury securities must provide a higher return. This is somewhat self-explanatory, of course.
If you didn’t have the potential for higher gains, it would make more sense to simply buy U.S. Treasury securities.
The Problem with MPT
The natural question is how do you assess risk? How do you know which is the best investment between your current option and Treasury securities according to MPT?
To assess risk, those who employ MPT look to the past for historical precedent.
This may seem sound enough. If you want to understand the future, look to the past, right?
What if the underlying assumptions about the past are wrong, though? In that case, the calculations made in the name of MPT are going to be inaccurately and potentially quite dangerous.
2007 was a good example of what can go wrong when everyone is looking for the best investment based on MPT. When things really started getting bad in 2009, the economic firestorm did not discriminate between value and growth, large cap and small cap or domestic and international. For the most part, everything got hit except for AAA-rated bonds.
How to Move Away from MPT
MPT is simply a concept that has outlived its usefulness. Too much has changed since it was first created. There is a lot more we now understand about investing and the market.
Many portfolios aren’t necessarily managed under MPT tenets, but might as well be. You may think you have the best investment possible because your money is in a 401(k) with a Target Date Fund. That’s definitely being managed with MPT concepts, though.
The same goes for a variable annuity with diversified portfolio options or even most managed accounts with financial advisors. You might be told you’re getting the best investment, but guess again.
Even the supposed “efficient frontier” approach is derived from MPT.
Unless you know your money isn’t being governed by MPT, it’s time to start moving to a system that utilizes unique markers for identifying undervalued stocks. This is the only way you can take advantage of inefficiencies in the market and wind up with the best investment for your money.
There are a lot of good services, such Seeking Alpha, which will help you to find right stocks to invest.
If you have some finite goals with defined time on the horizon, move your money to a dedicated portfolio of individual bonds. A portfolio of individual bonds will provide you a predictable return and assurance that your invested principal will be paid back just before your defined date. The power of compounding will reliably grow your capital without the stock market’s volatility.
If you still trust US banks, you can buy Wells Fargo (WFC) 3.00% Jan 22, 2021, or JP Morgan (JPM) 2.55% Oct 29, 2020, bonds, which both have YTM close to 2.5%.
If you’re ready to accept some more risk, a pipeline firm Kinder Morgan (KMI) 2.00% Dec 1, 2017, provides YTM 4.3% and a gold miner Kinross Gold (KCN) 5,125% Sep1, 2021 has YTM 10.2%.
Credit spreads have been recently widened and many bonds of great companies provide an attractive yield to maturity.
Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. All securities involve risk and may result in a loss. While bonds may provide an assurance of predictable return, there is a risk of default of particular issuer and there can be no assurance that an investment mix or any projected or actual performance will lead to the expected results shown or perform in any predictable manner.
Bonds are subject to interest rate, inflation, credit and default risk.The bond market is volatile.Investing in bonds in a raising rates environment, investors must be ready to see continually decreasing bonds prices and their recovering before maturity, and thus must be ready to keep bonds until maturity.
Although IncomeClub has detailed pre-selection process and trusts view and ratings of Moody’s and Standard & Poor’s , IncomeClub does not guarantee the quality of particular bond or that it will: 1) not be downgraded and notably loose its value; 2) not default until maturity; 3) recover all losses after default event; 4) be liquid or its market will be maintained.
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