Modern Portfolio Theory (MPT)
Is No Longer Optimal in Modern Markets
The world of investing today is “stuck” in the past. For decades we have been taught by the financial services industry that there is only one way to invest. That is by using Modern Portfolio Theory (introduced in the 1950’s) to create portfolios customized to match the risk tolerance of each investor via asset allocation methods. Then we are advised to hold these portfolios for the long-term with occasional rebalancing. Deviating from this approach is treated as a crime by financial regulators.
By using a 75-year old portfolio design methodology, investors are paying a steep price by holding outdated portfolios that produce low returns with high risk in modern volatile markets. This needs to change.
The NAOI Is Evolving the World of Investing
The information in this section of the Web site shows that MPT is not the only way to invest and not even the best. Here the NAOI has presents a different approach to investing called Dynamic Investment Theory (DIT). DIT creates Dynamic Investments (DIs), a new investment type designed to capture positive returns wherever and whenever they exist in the market based on a periodic sampling of asset class and/or market segment price trends. DIs don’t care about your risk profile. They only focus on maximizing profits and minimizing risk in all economic conditions. This is universal goal shared by all investors and, thus, no portfolio customization for each investor is needed.
Extensive testing by the NAOI has shown that the DIT approach creates investments and portfolios that can consistently and significantly perform better than any MPT portfolio for the same time period. Examples of this performance have been presented throughout this site - here for example. And we have shown that once the “chains” of MPT are broken all manner of positive outcomes that today’s experts will say are impossible suddenly become probable.
The NAOI believes that Dynamic Investments will play a significant role in defining the future of investing. As a result, investors and investment sellers will need to start “thinking differently” in order to take full advantage of this change.
Thinking Differently in a DIT-based Future of Investing
Below are listed areas of investing that change significantly when Dynamic Investment Theory (DIT) is used to create portfolios instead Modern Portfolio Theory (MPT).
The Portfolio Holding(s)
MPT portfolios are designed to hold both winning and losing investments at all times to reduce risk; but this also reduces gains.
DIT investments are designed to hold only winning investments at all times to both reduce risk and increase gains.
A Comprehensive Investment Type
MPT is a theory that simply shows how to match a risk tolerance level to a portfolio asset allocation that matches it. MPT provides no guidance for how to manage a portfolio on an ongoing basis; such as if or when to rebalance it. Management actions are left to subjective human judgments. Thus, MPT is not a comprehensive approach to investing.
DIT sets the rules for creating an investment type called Dynamic Investments (DIs) that not only specify the ETFs to use but also how they are to be managed on an ongoing basis. Thus, DIT creates comprehensive investments that are bought and held for the long-term while a built-in trading system changes the ETF held based on price trends.
A Universal Portfolio Goal
The goal of an MPT portfolio is to match the risk tolerance of each investor. Each must be customized.
DIT portfolios are designed to find and capture the positive returns, wherever and whenever they exist in the market. Their goal is to maximize returns and minimize risk. There is no need to customize these portfolios for each investor. This fact makes DIT-based portfolio design far simpler than MPT portfolio design and leads to the massive benefit discussed next.
The Productization of Investing
As mentioned above, MPT portfolios are customized for each investor. As a result they cannot be standardized and “productized”.
DIT portfolios have the universal goal of maximum returns with minimum risk in all market conditions - no customization is needed for each investor. As a result DIT portfolios can be treated as “products”; capable of being sold “off-the-shelf” from a variety of vendors. This “productization of investing” will have a massive and beneficial impact on how investing works today.
Additional Diversification Factors
MPT portfolios use both Company Diversification and Asset Diversification in order to reduce risk.
DIT portfolios also use Company and Asset Diversification but they also use two more as follows:
Time Diversification is used by requiring a periodic review of DI’s holding and making changes as necessary
Method Diversification is used when creating MPT/DIT Hybrid Portfolios that employ both a buy-and-hold and a buy-and-sell management strategy.
Time and Method Diversification both reduce risk AND enhance returns.
Returns and Risk
MPT states that higher returns are only possible by assuming higher risk
DIT disagrees. It shows that higher returns can be achieved without higher risk by placing more and different ETFs in a DI’s Dynamic Equity Pool (DEP).
An Automated Trading Plan
MPT portfolio trades, other than automatic rebalancing, are made primarily based on human subjective judgments.
DIT portfolio trades are made based on the objective observation of empirical market data. History has shown that “the market” is a far more accurate predictor of future equity prices than any human advisor or market analyst.
Stock Market Crash Protection Tools
MPT portfolios mitigate losses in the event of a market crash by holding both winning and losing investments at all times - i.e. owning uncorrelated assets. This methodology reduces losses during market declines and crashes but also reduces returns in stock markets that are trending up.
DIT portfolios are protected from significant value loss during a stock market crash via the use of Trailing Stop Loss Orders. In addition DIT portfolios are able to quickly sell stock-base ETFs when markets trend down and buy into bond. This enables DIs to not only avoid losses but to actually profit from stock market losses. DIs can also automatically switch back to stocks when a new uptrend has been established. Thus, unlike MPT portfolios, DIs are designed to hold only “winning” investments at all times.
Ease of Design
MPT designers select equities to place in a portfolio based on subjective judgments that are prone to all manner of errors. Mistakes made in this design process have a long-lasting effect as MPT portfolios are meant to be bought and held for the long term.
DIT designers select “groups” of equity candidates to place in a DI’s Dynamic Equity Pool and then let the “market” select which to buy, or hold, based on an periodic and objective sampling of the price trends of each. While MPT portfolio values passively move up and down with the tides of the market, DIs are constantly monitoring market movements and making changes to maximize returns while minimizing risk.
Greater Performance Potential
The DIT approach is capable of delivering performance that MPT portfolios can’t match and with lower risk. As an example, using the same two ETFs - one for Stocks and one for Bonds - the different approaches produced the following performance for the period from 2008 to 2021:
MPT using a 60% allocation to Stocks and a 40% allocation to Bonds and a buy-and-hold strategy
- Average Annual Return: +8.5%, Sharpe Ratio: 0..60
DIT holding only the one ETF that is trending up most strongly at the time of a quarterly review
- Average Annual Return: +25.1%, Sharpe Ratio: 1.07
Summary
The list could go on and on. But the above points are sufficient to show that when DIT, instead of MPT, is used as a basis for designing and managing a portfolio, investing outcomes that we are told by “experts” today are impossible, become probable. The use of DIT requires both investment buyers and sellers to “think differently”. And considering the complexity and risks of the way investing works today, it is about time.