On this Web page you will see how, using the same ETFs - one tracking a Stock Index and one tracking a Bond Index - an MPT portfolio earned an average annual return of + 10.3% while a Dynamic Investment earned an average annual return of + 26.7% with lower risk!
It's Time for Change
Since 1952 we have been taught that their is only one way to invest; that being by using Modern Portfolio Theory (MPT) to design asset-allocation portfolios that match each investor's risk tolerance. MPT is an approach introduced to the market in 1952 and remains today as the "settled science" methodology for portfolio design. Well, markets have changed significantly in the last six decades while MPT has not, and it no longer works.
In 2008 when the market crashed and MPT portfolios crashed with it, the NAOI decided that we could no longer teach it in our investor education classes. So we started a research effort to find a better approach to portfolio design and investing in general. In 2016 we found it in the form of Dynamic Investment Theory (DIT). It is designed specifically to work in modern markets and it does so amazingly well.
On this page the difference between MPT methods and DIT methods is explained in the simplest manner possible. Let's start by summarizing the main elements of each approach.
The Past: Modern Portfolio Theory (MPT)
Introduced in 1952 MPT directs us to design portfolios that match the investor's risk profile. This done by allocating money to multiple non-correlated assets, such as Stocks and Bonds. For example a more aggressive portfolio would have a higher allocation of money to Stocks while a conservative portfolio would have a higher allocation to Bonds.
The problems with this approach are many. MPT portfolios are designed to at all times hold both winning and losing investments. This reduces risk, certainly, but it also reduces returns. Plus defining an investor's risk tolerance is a very unscientific process, yet mistakes made here can have a significant effect on the investor's wealth generation potential.And MPT provides no guidance for how the portfolio is to be managed on an ongoing basis other to simply buy and hold it for the long-term. Any changes are totally dependent on subjective human judgments. MPT portfolios have no sensitivity to market changes and can be seen as "static" investments trying to cope with a "dynamic" market. They may have worked in 1952 but they don't work today.
The Future: Dynamic Investment Theory
In stark contrast to MPT portfolios, Dynamic Investments (DIs) are sensitive to market movements. They periodically monitor market trends and buy ONLY equities that are moving up while selling or avoiding those that are moving down. Buy striving to hold only "winning" investments, DIs are designed to produce returns that MPT portfolios can't touch. And because DIs embrace a buy-and-sell management strategy they are capable of stopping losses quickly before they can do too much damage. Another significant difference is that while the design of, and changes to MPT portfolios are based on risky, subjective human judgments, changes to DI holdings is based on objective observation of market trends. And history has shown that "the market" is a far better predictor of future price movements than any one or group of analysts.
Using Exchange Traded Funds
Dynamic Investments use Exchange Traded Funds (ETFs) almost exclusively for their holdings. ETFs are essentially mutual funds that trade like stocks. Thus, they work perfectly in a DI's buy-and-sell strategy. Plus, their exists an ETF for virtually every asset, asset type, market and market segment in existence. And their expenses are far lower than most mutual funds that are the vehicle of choice for most MPT portfolios.
MPT Portfolio Construct, Management and Performance
Now let's compare how MPT Portfolios work with how Dynamic Investments work.
The ETFs Used
For this purpose I will use the two ETFs shown at right, They are as follows:
EDV - This ETF tracks a long-term Treasury Bond index
RZG - This ETF tracks an index for Small-Cap, Growth Stocks
The MPT Portfolio Management Process and Performance for the period from the start of 2008 to the end of 2017
As illustrated below, Modern Portfolio Theory uses these ETFs by placing both in the portfolio with varying allocations of money. For this example I will simply assign a 50% allocation to Stocks and a 50% allocation to Bonds. In the real world an advisor would go through a messy process of first trying to figure out the investor's risk profile and then assigning allocations to Stocks and Bonds in a manner that matches it. This is a very subjective process and open to error. Then the portfolio is meant to be simply bought and held for the long term with the allocations adjusted to their original values each year.
Performance 2008 - 2017
Performance contains two elements as listed below. The Returns number shown is the average return for each of the 10 years in the period assuming all interest and dividends are reinvested when earned. The Sharpe Ratio is often used as a risk measure. It shows the amount of return received for each unit of risk taken.
- Average Annual Return: + 10.3%
- Sharpe Ratio: 0.79
You can see that the ETFs held and their allocations remained "static" throughout the period regardless of what the market was doing.
The Dynamic Investment Construct, Management and Performance
The process diagram below shows that the DI automatically measured the price trend of each ETF on a quarterly basis and bought, or held if already owned, the ETF with the strongest price uptrend for the previous quarter (not that the review period is at the discretion of the DI designer.) Thus, the DIs is dynamic and market-sensitive. It detects major market trends and is capable of responding to them in order to both capture gains and avoid losses. And remember, changes to the DI holding is based on objective price trends observations, not on the risk prone judgments of human analysts or advisors.
Performance 2008 - 2017
- Average Annual Return: + 26.7%
- Sharpe Ratio: 1.10
You can see the obvious superiority of the DI management process as compared to that of the MPT portfolio. By being both "dynamic" and "smart" the DI, using the exact same ETFs, earned almost 3x the return of the MPT portfolio with far less risk.
Today's "experts" will say that returns like this are impossible. But they are locked in the MPT box. When the investment methodology breaks out of that box all manner of "impossible" results become not only possible but probable. This is the advantage of "Thinking Differently" !
But, But, But .......
Skeptics will say that the use of a buy and sell strategy is not practical because of capital gains taxes. The NAOI says "nonsense". The returns of the DI are so superior that even taking a bigger chunk out of them for taxes still leaves them far above the returns of the MPT portfolio. Plus, most investing by the public today is done in retirement accounts where taxes have no effect on the amount of gains retained.
How and Why?
The Amazing Future of Investing book that can be purchased in the NAOI Store explains in detail why Dynamic Investments are superior in virtually every way to MPT portfolios. Below are just a few bullet-point highlights.
- DIs are market-sensitive, able to detect market trends and make changes to their holding to either capture gains or avoid losses. MPT portfolios are blind to market movements.
- DIs are designed to hold ONLY winning investments - i.e. those that are trending up in price at time of purchase. MPT portfolios hold both winning and losing investments at all times.
- DIs completely define the ongoing management process that results in automatic trade signals being generated. MPT says nothing about ongoing portfolio management other than to just buy and hold for the long term.
- DIs eliminate the risk of subjective human judgments in the design and management process. All changes are made based on empirical data. The MPT design and management process are rife with human subjective judgments leaving the door wide open to bad data, flawed analysis, sales bias, churning and even fraud.
- DIs are portfolio "products". Once created their design does not change but the ETF they hold does. This is an active investment with passive management. In DIs, the NAOI has found the Holy Grail of the financial world, i.e. The Productization of Investing. Like any other consumer products, DIs can be bought off-the-shelf from a variety of vendors and even sold via catalogs. This is a game-changer to say the least!
Reference new investing concepts page for more reasons why DIs are the superior product.
One Simple Example Only
The two-ETF Dynamic Investment shown in the above example is the simplest DI possible. Even greater returns can be achieved by designing the DI to be able to choose from more ETFs in its search for stronger uptrends at a Review period. DIs open a vast new world of new product development.
Just to summarize: Using the same two Exchange Traded Funds (ETFs) the Dynamic Investment construct earned 3x the average annual returns of the MPT construct and with less risk and no human judgments required. The world of investing has just changed at a fundamental level!