Based on 20+ years of teaching individuals how to invest, the NAOI knows that a major problem with the way investing works today is the exclusive use of Modern Portfolio Theory (MPT) methods for creating investment portfolios. This page discusses just a sampling of these problems and why they are keeping too many people who need investing income out of the market today.

A Review of MPT Methods

MPT sets rules for the design and management of portfolios that are offered to clients by virtually all financial advisors today. The goal of these portfolios is to match the risk profile of each investor via allocation of money mainly between Stocks and Bonds. The general assumption is that higher allocations to Stocks results in higher-return, higher-risk portfolios while lower-risk portfolios are given a larger allocation to Bonds. Once a risk tolerance level is determined, MPT uses statistical analysis to recommend a portfolio asset allocation that matches it.

MPT also dictates that once a portfolio is designed for an investor it is to be bought and held for the long-term with periodic reviews to rebalance the portfolio to return it to original allocations - although the frequency of rebalancing is not specified by MPT and is typically performed at the discretion of an advisor.

Questioning MPT Methods

The NAOI taught the use of MPT portfolios to the investing public for over a decade and our organization did quite well. Thousands of individuals have taken our online courses, read our books and/or attended our college classes. Yet when the market crashed hard in 2008-2009 we watched in dismay as the MPT portfolio we had taught our students to create crashed with it.

At that point we began to question the benefits of using MPT as the only method for creating and managing investment portfolios. NAOI President, Leland Hevner, made the decision that the organization could no longer teach the use of a portfolio design methodology that put people’s life savings at almost unlimited risk of losses when markets crash.

Seeing that fundamental change was needed, Hevner shifted significant NAOI resources from Education to Research-and-Development in order the find an alternative to, or supplement for MPT methods; one that could better cope with modern volatile markets and better meet the wants/needs of investors.

The Development of Dynamic Investment Theory (DIT)

Based on a multi-year R&D effort, the NAOI met our goal of developing an MPT alternative with the development of a new approach to portfolio design that we called Dynamic Investment Theory (DIT). This approach creates market-sensitive investments that we called Dynamic Investments (DIs) and Dynamic Portfolios (DPorts) that are capable of automatically changing the ETFs they hold based on a periodic sampling of market trends. By being “market-sensitive”, they are capable of producing significantly higher returns than traditional MPT portfolios, in both Bear and Bull markets, with lower risk and no active management required.

The NAOI is now teaching our students the use of DIT in addition to MPT for portfolio design and management. And the demand for the DIT approach is growing fast.

Top Problems Related to the Use of MPT and how DIT Fixes Each

Listed below is just a sampling of the problems that the NAOI found as being related to the exclusive use of MPT for building portfolios today. We are currently encouraging NAOI students to hand this list to any advisor candidate that they are interviewing and asking them to comment on each issue and how they would address it. Also presented in this list for each problem is how Dynamic Investment Theory and Dynamic Investments solve it.

1. MPT is Out-Dated

Modern Portfolio Theory was introduced to the market in the 1950’s when equity markets were a far different place than they are today. While equity markets have evolved significantly since then, MPT has barely changed at all and the portfolio design and management methods it mandates simply can’t cope with modern market dynamics.

• DIT was developed specifically to create portfolios that thrive in today’s uncertain and volatile markets.

2. Investor Risk-Tolerance Is A “Guesstimate”

The goal of MPT is to match the risk tolerance of each investor. Yet risk tolerance is an ambiguous measure at best. A major factor that advisors use to determine risk tolerance is how investors “feel” about losing money. No investor is trained to make such decisions - so they typically just guess at an answer. Yet, since risk tolerance is the major factor that determines how MPT portfolios are designed and the returns that can be expected for many years in the future, a mistake made here will have long-lasting negative effects on the investor’s financial future. Thus the MPT portfolio creation process starts with a very shaky assumption and only gets worse as described in the list below.

• DIT-based portfolios are designed with the universal goal of maximizing returns while minimizing risks in all market conditions. This is a universal goal that works for all investors regardless of their risk profile. Thus, no customization based on a “guess” at risk tolerance is needed.

3. Portfolio Allocations are Fluid

As discussed above, MPT portfolios are designed to match an investor’s risk tolerance using asset allocations between mainly Stocks and Bonds. Aggressive portfolios have a larger allocation of money to stocks. Conservative portfolios have a larger allocation to Bonds. Once designed and purchased, MPT portfolios are then meant to be bought and held for the long term. But immediately after purchase a portfolio’s risk profile begins to change as Stock and Bond prices move up and down. Thus, if Stock prices go up a conservative portfolio can quickly become a very aggressive and risky portfolio. Yet the MPT buy-and-hold rule does not allow for the frequent trades needed to retain the original risk levels. And when investors are profiting from uptrending stocks they are very reluctant to sell them. The only remedy for this problem is periodic portfolio rebalancing; but that has problems too as discussed Point 4, below.

• Because DIT-based portfolios are not designed to match an investor’s risk tolerance the problem of portfolios changing their risk profile goes away. They are designed to maximize returns while minimizing risk in all market conditions.

4. The MPT Portfolio “Rebalancing” Dilemma

Point 3, above, discusses the potential of MPT portfolios changing their risk profile quickly after purchase as the prices of stocks and bonds move up and down and change asset allocations. The only way to bring these portfolios back to their original allocations and risk level is via a periodic rebalancing that is initiated by an advisor. Yet, such portfolio changes are typically performed only once per year in order comply with MPT’s buy-and-hold dictate and to avoid short-term capital gains. This rebalancing dilemma can leave investors holding portfolios that are either too risky or too conservative for an extended period of time as today’s markets can change very quickly. And the negative consequences can be severe.

• DIT portfolios make trades based on market trends. There is no need to try to maintain a specific asset allocation. Thus, rebalancing is not required.

5. The Dependence on Stocks and Bonds being “Inversely” Correlated.

MPT portfolio design methods make the assumption that when stock prices trend down, bond prices trend up and vise-versa. In other words they are negatively correlated. MPT methods fail if this correlation changes . Unfortunately there are times when both Stocks and Bonds trend down at the same time, as they do when interest rates rise - a condition that the market is experiencing as these words are written. The problem is that MPT assumes that by holding both Stocks and Bonds there will always be a portion of the portfolio moving up in price. When both asset classes trend down, MPT portfolios are in danger of losing a significant amount of their value.

• Trained designers specify the ETFs that each DI and DPort will work with by including them in the DI’s Dynamic ETF Pool (DEP) as shown in the diagram presented above. At a periodic review (e.g. quarterly) DIs purchase, or continue to hold if already owned, the ETF in the DEP that is trending up most strongly in price. Most of the time the DI will select either a Stock or a Bond ETF. But the DEP can also include ETFs that track other asset classes such as Commodities and Gold. Thus if both Stocks and Bonds are trending down, the DI will have other options to find an ETF tending up. In the rare instance where no ETF in the DEP is trending up, the DI will go to “cash” by purchasing a short-term Treasury Bond ETF and essentially stay out of the market until the next DEP review event when it searches again for an ETF that is trending up.

6. The Problems of Holding Both Winning and Losing Equities at All Times

MPT dictates that portfolios hold both winning and losing assets (e.g. Stocks and Bonds) at all times to lower risk. Thus the portfolio will always hold equities that are falling in price. As a result MPT does not enable investors to take full advantage of uptrending markets - there is always a portion of the portfolio pulling its returns down. While MPT allocation methods do reduce risk, they also reduce returns.

• DIT portfolios purchase ONLY ETFs tracking asset classes or areas of the market that are trending up in price. As a result, investors are able to take full advantage of gains wherever and whenever they exist in the market. The risks related to these gains are mitigated by periodic reviews of the ETF held, and changes if needed, as well as the use of Trailing Stop Loss Orders on the ETF currently held.

7. The Dangers of a Buy-and-Hold Management Strategy

The fact that MPT dictates a buy-and-hold portfolio management strategy exposes its value to risk of significant losses. These portfolios have no safety-net that automatically stops such losses by selling ETFs that begin trending down. The NAOI knows from student surveys that this fact is keeping many people who need investing income out of the market.

• DIT-designed portfolio allow gains to run as high as possible and automatically stop significant losses quickly. This feature, alone, will enable scores of individuals to enter the market with confidence and without fear.

8. The Risks Related to Subjective Human Judgments

MPT portfolio design and management decisions are heavily reliant on subjective human judgments and this fact inserts a massive risk element into the investing process. These subjective judgments include determining an investor’s risk profile, defining which specific equities to include in a portfolio, when to rebalance the portfolio and when / how trades are made. The only decision that is based on “science” is matching a portfolio risk level with an asset allocation. Thus, the quality of a portfolio is heavily reliant on the competence and honesty of the advisor an investor chooses to work with. This is a MAJOR problem that makes even the most conservative portfolios very risky as advisor decisions can be made based on bad data and/or incorrect analysis. And while a large majority of advisors are honest, some will recommend investments based on the commissions they receive. Trades made based on subjective human judgments also opens the doors to all manner of activities that are not in the investor’s best interest - e.g. account “churning” and even outright fraud.

• DIT portfolios are designed by trained professionals and once created no further human judgments are required to manage them. They have a built-in trading plan that automatically signals trades based on a periodic sampling of the price trends of the ETFs in the DEP. By using objective observations of market data to make trades as opposed to subjective human judgments, DIT management methods remove a massive area of risk from the investing process and give investors the confidence needed to enter the market without fear.

9. Not Taking Advantage of Retirement Plan Tax Benefits

One major advantage of Retirement Plans is that a portfolio’s value can grow without being taxed until money is withdrawn beginning at the investor’s retirement age. Then it is taxed at personal tax rates. There is no penalty in the form of short-term capital gains taxes for frequent trading. Yet advisors still recommend that individuals place buy-and-hold, MPT-based portfolios in these plans. As a result investors are not taking advantage of one of the most significant benefits Retirement Plans offer - namely the ability to make trades that take advantage of market changes with no penalties.

• DIT portfolios use a buy-and-sell management plan to both capture the gains of uptrending areas of the market and to avoid the losses of those that are trending down. This often requires frequent (e.g. quarterly) trades based on a periodic sampling of market trends. By being market-sensitive DIs and DPorts are capable of producing returns that are not possible today using buy-and-hold methods. Effective retirement portfolios must be designed to take advantage of this benefit.

10. The Unchallenged Assumption that Higher Returns Only Come with Higher Risk

A key concept of MPT is that higher returns come only with higher risk. The MPT methodology falls apart if this is found to be not true. DIT shows that it is not true. Dynamic Investments can produce higher returns without higher risk by adding more ETFs to its Dynamic ETF Pool. For example, a DIT portfolio that rotates only between owning a total stock market ETF and a total bond market ETF based on the price trends of each earned an annual return of approximately +17% for the period from 2008-2021, By adding one additional ETF that tracks small-cap stocks to the purchase candidate pool (the DEP) the average annual return increased from 17% to +21%. And it did so without additional risk. Thus, DIT methods show that MPT’s core assumption is wrong.

• DIT portfolios can produce higher returns without higher risk by adding more ETFs to their “Dynamic ETF Pool” and, by doing so, giving the portfolio more areas of the market to search for uptrending prices.

11. Addressing the Needs of Less Affluent Investors

A disturbing factor that is becoming more and more common in the financial services world today is that financial advisors are only accepting high net worth clients - over $250,000 in many cases. The reasoning for this requirement is that the analysis and work needed to create a quality, customized MPT-based portfolio is too costly to expend on low net worth clients. As a result, a large number of potential investors are not being well-served by the financial community today.

• High-performance DIT portfolios are extremely easy to create and manage by advisors who have been trained by the NAOI to do so. Most DIT portfolios will provide higher returns with lower risk than virtually any MPT based portfolio in use today. In fact, because DIT portfolios do not require customization to match each investor’s risk level, the NAOI has created a “Universal Portfolio” product that consistently produces higher returns than industry averages. This is a portfolio that advisors can provide to the investing public at a very low cost and, by doing so, enabling them to capture a massive potential market that is being ignored today.

12. Trust in Investment Advisors is Eroding

A major factor that is keeping thousands of individuals out of the market today is that they don’t understand the MPT-based portfolios they are given by advisors. Nowhere in academia or any other venue have they been trained how to evaluate the quality of the advice they are given by investment advisors. So, to participate in the market they have little option but to simply entrust their financial futures to a third party advisor and hope for the best. People are increasingly reluctant to do so.

• DIT-based portfolios solve this problem by being extremely simple to understand. NAOI students who have learned how DIs and DPorts work tell us that this is the approach that will enable them to enter the market with confidence.

Perspective

You will note that the title of this Web Page is “Why Modern Portfolio Must Be Challenged”, not “Why MPT Must Be Replaced”. It is NOT the intent of the NAOI to replace MPT with DIT; both methods provide unique benefits to investors. And MPT and DIT work quite well together. For example using Dynamic Investments as building blocks in MPT portfolios both enhances the portfolio’s returns while lowering its risk. Thus, while the financial services industry currently sees MPT as the only choice for portfolio design and management, the NAOI sees three choices as follows:

• Modern Portfolio Theory (MPT)

• Dynamic Investment Theory (DIT)

• MPT + DIT to create what we call Dynamic Portfolios (DPorts)

Three options for portfolio design and management instead of one open a vast new world of investing possibilities and the creation of superior wealth building solutions that are not possible today. This Web Page shows why and how investors must challenge advisors who use only MPT methods for the portfolios they are offering. The MPT problems listed on this page are provided to enable both retail and corporate investors to do just that. If advisors don’t have good solutions for these problems, they need to work with the NAOI to learn about DIT. Those that do so will thrive in the future of investing that is currently being defined and taught by NAOI.

An NAOI Dynamic Portfolio Example

The following diagram shows the configuration of an NAOI Dynamic Portfolio that contains both and MPT, buy and hold, Segment and a DIT buy and sell Segment. The percent allocations are at the discretion of the advisor. For this example, when stocks are trending up the portfolio allocation is 80% Stocks and 20% Bonds. When stocks are trending down it is 20% Stocks and 80% Bonds. These changes are made by the DI Segment rotating between 100% ownership of either Stocks or Bonds based on a quarterly review of the price trends of each.

Dynamic Portfolios enable financial organizations to include a Dynamic Investment building block to any MPT portfolio they are currently offering in order to both increase its returns and lower its risk. Alternatively, an individual investor can easily implement the Dynamic Investment Segment on their own. The NAOI can show them how.

The Advantages of Working with the NAOI

DIT is a very simple but profitable approach to investing. Dynamic Investments and Dynamic Portfolios that outperform virtually any MPT-based portfolio can be easily created by advisors who read the NAOI White Paper referenced above. However, to create optimal DIs and DPorts and to take full advantage of their value, working with the NAOI is strongly suggested. We have been designing Dynamic Investments and Dynamic Portfolios for over three years and we know what works and what doesn’t. The various forms of cooperation can be found at these links: Consulting, Partnerships.

NAOI President, Leland Hevner, is also available to serve on the Advisory Board of financial organizations who can benefit by taking advantage of his unmatched knowledge of the wants/needs of the investing public as well as his unique vision for the future of investing.