The NAOI knows that change does not come quickly in the financial world. While holding only one Dynamic Investment in a portfolio can be a very profitable decision, NAOI students have shown a strong preference for easing-in to the new dynamic investing approach. This is easily done with what we call MPT/DIT Hybrid Portfolios that hold both “static’ building blocks and at least one “Dynamic Investment” building block. The process and performance of this new approach to portfolio design are discussed on this page.

Here you will see that it is not the purpose of the NAOI to complete replace MPT methods with DIT methods. Each can complement the other in a well-designed Hybrid Portfolio.

The Problem with Portfolios Today

The NAOI sees as a major problem that today’s portfolios are static investments. Designed using an approach called Modern Portfolio Theory (MPT) the goal of these portfolios is to match the risk tolerance level of each investor using asset allocation methods. Then they are meant to be bought and held for the long-term with perhaps a yearly rebalancing to maintain original allocations. They are completely blind to market dynamics and their value drifts up and down with the tides of the market. As a result, they are dangerously vulnerable to market crashes as we saw in 2008-2009 and the start of 2020.

NAOI MPT/DIT Hybrid Portfolios

The NAOI solves this problem without major disruption to current methods via the use of what we call MPT-DIT Hybrid portfolios that use both methodologies as illustrated in the diagram just below. An investor or advisor can decide how much portfolio money to assign to each method. In this manner, DIT enables a new diversification type that we call “methodology diversification”. Added to the “time-diversification” provided by Dynamic Investments, this portfolio configuration takes advantage of four diversification elements: company, asset, time and methodology. It is for this reason that they will play a dominant role int the future of investing.

An Example: The NAOI “Market Biased” Portfolio

Below is an example of one way in which an NAOI Hybrid Portfolio can be structured. We call it the NAOI “market-biased” portfolio. It has buy-and-hold Stock and Bond components (on both ends of the diagram below) with the allocations shown plus a Dynamic Investment (DI) (in the middle of the diagram) that alternates between a Stock and a Bond ETF based on a periodic review of the price trend of each. This portfolio is thus capable of changing the asset class “bias” to either Stocks or Bonds depending on which is trending up more strongly at a quarterly Review Period. No subjective decisions are required to make this change and the process can easily be automated.

Hybrid Portfolio Components

Lets look at the configuration of this portfolio in different market conditions.

When Stocks Are Trending Up

The diagram below shows the allocations of this dynamic portfolio when the stock asset class is trending up. The 80% Stock allocation is the sum of the 30% buy-and-hold Stock ETF building block plus the 50% allocation of Stocks from the Dynamic Investment that automatically “senses” the uptrending asset class at a Quarterly Review.

When Bonds Are Trending Up

The diagram below shows the allocation of the portfolio when Bonds are trending up at a Quarterly Review.

This portfolio is “asset-fluid”. At any one point in time it will hold an allocation of either 80% Stocks / 20% Bonds or 70% Bonds / 30% Stocks. These asset allocations DO NOT depend on the investor’s risk tolerance; they depend on current asset price trends. This Dynamic Portfolio strives to hold an asset allocation that at all times is biased toward the asset class that is trending up in price. This is a new and better way of investing as illustrated in the performance numbers shown next.

Performance 2008-2019

The Table below shows the annual returns for the test period from 2008 to 2019 of the example Hybrid Portfolio discussed above in the first data row. For comparison purposes the second data row shows the performance of an MPT portfolio that simply buys and holds the same asset classes using the allocations shown. The last two rows show the average annual return of each portfolio along with the Sharpe Ratio which is a measure of how much return is realized for each unit of risk taken - and the higher the better.

It can easily be seen that the performance of the dynamic Hybrid Portfolio was significantly higher than that of the static MPT portfolio. Not only were the Returns higher but the Risk was actually lower as indicated by the increased Sharpe Ratio. Today’s experts will say that performance like this is impossible. And it is using static MPT portfolios. But when a dynamic building block is inserted into the portfolio, it becomes market-sensitive, and this makes a world of difference as the Table above shows.

Two Additional Diversification Factors

The NAOI Hybrid Portfolio’s higher performance reflects the addition of two new diversification elements. Like MPT portfolios, Hybrid portfolios take advantage of both Company and Asset diversification. Both provide vital risk reduction benefits. But that’s all that MPT portfolios provide. NAOI Hybrid Portfolios add two additional diversification elements as follows:

• Time Diversification - Because the Dynamic Investment building block reviews, and changes if necessary, the asset class it owns on a quarterly basis, it is time-diversified. MPT portfolios, because the use a buy-and-hold strategy are not. Time diversification not only reduces risk it also enhances returns.

• Methodology Diversification - The Hybrid Portfolio is also '“methodology” diversified, using both a buy-and-hold strategy for the static building blocks and a buy-and-sell management strategy for the dynamic building block. This diversity reduces risk and enhances returns as well.

Adding new diversification elements to a portfolio is evidence that with the introduction of Dynamic Investments the world of investing has changed at a fundamental level. And positive outcomes seen today as impossible, suddenly become probable.

An Example MPT to DIT Transition Strategy

The Table below shows multiple allocations for each of the building blocks in the example Hybrid Portfolio discussed above with allocation to the Dynamic Investment gradually increasing. The top data row is a 100% MPT portfolio and the bottom data row is 100% Dynamic Investment portfolio. The rows in-between show allocations and performance for Hybrid portfolios that utilize both MPT and DIT methods. For each allocation-set the final two columns show average annual returns and risk for the period from 2008 to 2018.

This chart very clearly shows how even a small increase in the allocation of money to a Dynamic Investment can significantly increase the returns of an MPT portfolio without increased risk. It also shows how investors and financial advisors can transition from MPT to DIT methods in a controlled manner.  

The NAOI Market-Biased Portfolio - The Perfect Default 401(k) Investment

The Hybrid Portfolio discussed at the top of this page is called the “NAOI Market-Biased” portfolio. Its allocations are automatically biased toward the asset class that is moving up most strongly in price.

The NAOI Market-Biased Portfolio is the perfect “default” investment for a 401(k) or other type of retirement account. In a tax-deferred retirement account there is no penalty for frequent trading. And its high returns combined with low risk puts today’s default investment - Target-Date Funds - to shame. Add to this the fact that changes to the allocations of this portfolio can be automated with no human judgments involved. This is how a “default” 401(k) investment should be defined.

A Vast New World of Product Research and Development

In the limited space available here, I can only touch on the vast number and variety of configurations that the introduction of Dynamic portfolio building blocks makes available to portfolio designers. NAOI offers DI and Dynamic Portfolio Design Training as discussed at this link. The potential for major competitive advantage for financial organizations that offer MPT-DIT Hybrid Portfolios is off-the-charts.