Input from NAOI students tells us that far too many people who need investing income are not participating in the market today. Why? Because they are not willing to expose there savings to the risks of owning the static, buy-and-hold MPT-based portfolios in modern volatile markets. Below are listed just a few of the reasons why MPT methods are not optimal in modern markets and why change is needed. We teach our students to discuss these issues with their advisors before accepting an industry-standard MPT portfolio.

The Problems of Modern Portfolio Theory (MPT) Methods In Modern Markets

The public’s fear of investing today arises primarily from the fact that virtually all individuals are given by their advisors portfolios created using an approach called Modern Portfolio Theory (MPT). Introduced to the market in the 1950s, MPT dictates that portfolios be designed to match the risk tolerance of each investor using asset allocation techniques, typically between Stocks and Bonds. Then investors are told to simply hold these portfolios for the long-term. While the MPT buy-and-hold approach has advantages, it also has problems. Here are just a few:

An Outdated Theory - Modern Portfolio Theory (MPT) was introduced to the market in the 1950’s. While markets have evolved significantly since then, MPT has barely changed at all. By not adapting to market changes MPT neither enables today’s investors to take full advantage market gains nor to protect them from significant market losses.

An MPT Portfolio’s Risk Profile Constantly Changes – MPT portfolios are initially designed to match an investor’s risk tolerance using asset allocations, typically between Stocks and Bonds. Aggressive portfolios get a larger allocation to Stocks. Conservative portfolios get a larger allocation to Bonds. Yet, immediately after they are purchased, an MPT portfolio’s allocations begin to change as Stock and Bond prices move up and down. But MPT advises against making the frequent trades needed to maintain the portfolio’s original risk profile. And a conservative portfolio can become an aggressive portfolio very quickly when Stock prices rise. As a result, a significant number of people today are holding portfolios that do not come close to matching their risk tolerance. And they are often shocked at the size of their losses when the stock market falls.

The Dependence on Stocks and Bonds being Negatively Correlated - MPT portfolio design methods assume that when Stock prices fall, Bond prices rise and vise-versa. Yet there are times when both Stock and Bond prices trend down together, as they did in 2022 in response to rising interest rates. When both major asset-classes trend down even the most conservative MPT portfolio can lose significant value.

The “Human Risk” Factor – MPT shows advisors how to determine a portfolio’s asset allocations (primarily between Stocks and Bonds) that match an investor’s risk tolerance. That’s about it. The theory provides no guidance for taking gains or for stopping losses. These critical decisions are left to the subjective judgments of investment advisors and this injects a massive “human-risk” element into the investing process. These risks can include the use of bad data, incorrect market analysis, sales bias, inappropriate trades and even scams/fraud. Thus, the effectiveness of an MPT-based portfolio is heavily dependent on the competency and the honesty of the advisor who designs it. And determining the quality of an advisor is difficult, at best, for the average investor.

External Market-Risk Factors – Markets rise and fall due to an almost unlimited number of factors that have nothing to do with the analysis of corporate financial statements that serve as the basis for most investing decisions today. Among these factors are pandemics (e.g. COVID), natural disasters, cyber-attacks to critical infrastructure, algorithmic trading, government regulations, global unrest, trade wars and more. Yet buy-and-hold MPT portfolios are essentially “blind” to these external risk factors that can decimate a portfolio’s value virtually overnight.

Mediocre Returns – Using MPT methods, portfolio risk is reduced by purposely holding at all times both winning and losing investments (e.g. Stocks and Bonds). Of course this strategy also reduces returns. People tell us that they don’t view average annual portfolio returns of 7% - 9%, at best, as being worth the risk of potential losses of 20% and higher.

The Under-Used Ability to Automatically Stop Significant Losses – A valuable tool available to investors today is an order type called Trailing Stop-Loss (TSL) orders. They automatically sell a stock if its price drops by an amount defined by the portfolio designer. A TSL differs from a Stop-Loss order in that the “sell” price moves up as the price of the stock moves up, but does not go down if the stock price falls in price. As a result any gains from the stock purchase price are protected by a TSL. But TSLs can’t be placed on Mutual Funds, the investment type most commonly used in MPT portfolios leaving them dangerously vulnerable to significant losses. However, TSLs can be, and are, placed on the ETFs held by NAOI Dynamic Investments. They provide the protection from significant losses that investors today not only want, but need to participate in the market. The NAOI Research Report shows how.

No Recognition that “Time Is Money”. Investment advisors defend the use of MPT methods by telling their clients that in the long-term a buy-and-hold portfolio management strategy is almost always profitable. And they are correct. But what they often don’t mention is that in the short-term a buy-and-hold strategy can result in significant losses and the time required to recover the loss can be measured in years. This is time not used to increase original portfolio value. And, as we all know, time is money.

The NAOI Does NOT Suggest Eliminating MPT Portfolios

It is important to note that the NAOI does not recommend that MPT portfolios be eliminated. We simply show our students the information presented above and encourage them discuss these problems with any advisor that they are using or interviewing. The NAOI Research Report that is now available to readers via the “Invitation” Web page on this site shows how the use of Dynamic Investments (DIs) address each of these MPT problems.

We also encourage students to ask their advisor to include DIs in their offerings. If the answer is “no” individuals can easily implement them on their own using an online broker. The NAOI shows them how in our “Dynamic Investment User’s Manual” that is currently available in the NAOI Store.