Previously on the Invitation Web page I provided a link to a page entitled “Why Modern Portfolio Theory Must Be Challenged”. On this page I repeat the problems followed by a discussion of how Dynamic Investment and Dynamic Portfolios solve these problems.

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.

Dynamic Investment Theory (DIT), created by the NAOI, is specifically designed to create portfolios that thrive in today’s uncertain and volatile markets. By embracing a “market-sensitive” approach using Dynamic Investments it evolves portfolio design and management methods into the 21st Century.

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 MPT portfolios use to design portfolios for individuals today, a mistake made here will have long-lasting negative effects on an 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 - both Bear and Bull. This is a universal goal that works for all investors regardless of their risk profile. Thus, no customization based on a “guesstimate” of an individual’s 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 only to match an investor’s risk tolerance the problem of portfolios changing their risk profile goes away. Their primary design goal is 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, as needed, based on market price trends. They automatically change asset class allocations to take advantage of current market conditions. There is no need to rebalance a portfolio revert to an original risk tolerance level.

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 on the Invitation Web Page. 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 trending 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 such as “BIL” 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 as well as the use of Trailing Stop Loss Orders placed 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 while automatically stopping 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. The use of objective observations of market data to make trades as opposed to subjective human judgments removes a massive area of risk from the investing process and gives 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 able to take advantage of one of the most significant benefits Retirement Plans offer - namely the ability to make trades that capture gains when markets trend up significantly and avoid losses when markets trend down 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. MPT, buy-and-hold portfolios do not.

10. The Retirement “Default Investment” Dilemma

Today the “default” investment type that advisors recommend for retirement plans is the Target-Date mutual fund or ETF. This investment gradually increases the portfolios asset allocation to Bonds while lowering the allocation to Stocks. Of course this means that the portfolio will have an expected return that decreases significantly as people reach retirement age. The problem is after retirement the need for investing income increases, significantly. This is one of the major dilemmas in the world of investing today.

As explained on this page, DIT-based portfolios are designed to take maximum advantage of current market conditions using Dynamic Investments. They are NOT designed to match an individual’s risk tolerance. Thus, there is no need to increase allocation to Bond as retirement approaches and by doing so lower expected returns. The “default” retirement fund of the future will be a Dynamic Portfolio similar to the one discussed in Point 11, below.

11. 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.

12. 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. It is illustrated in the diagram below.

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. It will also serve as the “default” investment in the future of retirement plans - providing retirees with returns that are far higher than Target-Date funds, today’s default-investment, without higher risk.

13. 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.

Summary

On this page you have read how the use of Dynamic Investments and Dynamic Portfolios changes the world of investing at a fundamental level. By doing so this new approach to portfolio design and management is able to cope with 21st Century markets far more effectively than static, buy-and-hold MPT portfolios that were introduced in the 1950’s.