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Building Portfolios Beyond Modern Portfolio Theory: How Advisors Can Add Value

With investing news and information instantly available to the public, investors have taken a do-it-yourself approach, allocating assets in seconds with one of the many available apps on their smartphone. The financial services industry’s chorus calls of conventional investing wisdom such as “buy and hold” and “portfolio diversification” have left investors with significant losses during bear markets and long-term underperformance. Advisors and managers failing to prove their value are being left behind for cheaper alternatives. The commonly held belief that it is impossible to time the market has led to a mass influx into low-cost, market-tracking products with providers racing to lower fees, no fees, or even negative fees. Our experience indicates investors rarely buy and hold through catastrophic bear market losses. This is where financial advisors can add value for investors. We believe diversification alone has failed to materially reduce loss as liquidity trap market events become more common and cause asset correlations to increase. As a consequence, diversification alone will not be enough to protect investor capital from large losses during the next downturn.

It is time to accept that the investor “herd effect” has become one of the most powerful and dominant market forces with panic-selling across asset classes overwhelming non-correlation and diversification. It’s time for the industry to adapt and to stop misleading investors on how to win at investing. We need to move beyond conventional theories to build more advanced portfolio concepts, integrating diversification with active management systems that can intervene to reduce risk and loss in market meltdowns within investors’ stated tolerance levels. We believe the best financial advisors add value by helping increase client success through both good and bad market cycles. Clients need advisors who can help them by determining their personal benchmarks for loss tolerance and the required rate of return. Portfolio design should incorporate these client benchmarks to build a structure that has the highest probability of achieving the desired outcome. Ongoing education and coaching by advisors can help anchor client expectations so they don’t succumb to “fear of missing out” on return (FOMO) or “fear of not getting out” (FONGO) before incurring large losses.

Investors Don’t Buy and Hold

Our experience with thousands of investors shows that they rarely buy and hold through bear market cycles. While investors often try to stay the course in bear markets, they tend to end up bailing on their investment plan as market losses exceed their tolerance point. Selling near cycle lows can cause so much loss of capital, it often compromises their financial future. Even worse, after incurring losses, they sit on the sidelines as markets start to rally and wait years to reinvest. Then as FOMO takes hold, investors end up buying high once again and set themselves up to sell low in the next bear market decline as FONGO creeps in. Investor behavior suggests they don’t make a conscious choice to try and time the markets; instead, they are driven from the markets when they experience more loss of capital than they can tolerate.


Source: Investment Company Institute, 2017. Past performance is not indicative of future results.

The Investment Company Institute Fund Flow Reports have documented the phenomenon of investors failing to buy and hold for decades (Chart 1). Recently, J.P. Morgan illustrated the performance results of these sad facts in a report showing investors have captured a paltry 1.9% per year return versus a buy-and-hold investment in the S&P 500 that posted a 5.6% annualized return (Chart 2). It seems it is high time advisors and investors ask themselves why they should try to follow conventional buy and hold investing wisdom that has caused many investors to underperform the market severely.


Source: J.P. Morgan Asset Management. 2Q 2019 Guide to Markets, 2019. Past performance is not indicative of future results. Indices are unmanaged and may not be invested in directly.

“Modern” Portfolio Theory Got Trampled by the Herd

The industry’s reliance on Modern Portfolio Theory (MPT), an antiquated patchwork of theories that are anything but modern, has also been damaging to the investor psyche. MPT traces its foundation back to Harry Markowitz’s “Efficient Frontier Theory,” penned in the 1950s. A theory that is almost seventy years old and created before broad adoption of computers, WiFi, cell phones, and the internet should not continue to be characterized as modern. That is not to say that Markowitz’s Nobel Prize-winning work lacked significance. On the contrary, the idea that you can create higher return portfolios with lower risk by including assets that work together to reduce correlation and increase covariance is still a powerful portfolio modeling concept even today. As it turns out, the portfolio risk reduction benefits of diversification work just great, except in big market declines when you need it most to protect yourself from devastating losses. Even Markowitz himself has said there are times when non-correlation between asset classes breaks down. The recent Financial Crisis was one such example of how when asset class correlations converge, it severely reduces the risk reduction benefits of diversification.

We believe the broad adoption of the internet in the late 1990s and early 2000s fundamentally changed the investing landscape by disseminating financial information worldwide for free. As a result, the continuous information loop increased investor behavioral bias within markets. The power of the investor “herd effect” to move markets has drastically increased as investors move en masse when they become fearful of loss or afraid of missing out on return.

We see the herd effect as the driving force when markets are under pressure. FOMO in the late 1990s caused investors to bid up overvalued tech stocks, creating a “tech bubble.” The NASDAQ Index’s spectacular rise of 85% in 1999 shined a spotlight on the power of the herd. The herd effect was even more evident in the bursting of the bubble as investors became fearful of loss and rushed to sell tech stocks in 2000. The mass exodus drove the NASDAQ down by almost 80%. A similar herd effect was also one of the culprits behind the startling 2008 Financial Crisis declines as investors sold investment assets to reduce risk. Selling pressure from around the globe turned the rout into a liquidity crisis, increasing correlations across all asset classes. The herd effect has become a dominant investing force, at times causing correlations to increase exponentially until all asset class prices are moving together.

“The power of the investor ‘herd effect’ to move markets has drastically increased as investors move en masse when they become fearful of loss or afraid of missing out on return.”

In the bear market, while a few asset classes held up well and produced the expected non-correlation effect, it was not enough for investors depending on diversification to avoid severe losses. In the Financial Crisis, non-correlation between asset classes all but vanished, giving investors no place to hide from devastating losses. We believe the herd effect will continue to increase in intensity as central bankers around the globe attempt to control investor expectations with policies designed to keep markets stable and consumers spending. At best, this is a risky bet by central bankers and one that may have little hope of achieving long-lasting stability across financial systems, economic regimes, and markets.

The Low-Cost Frenzy

Equally ridiculous are the constant recommendations to only invest in low-cost passive index products based on the assertion that “average” active managers do not outperform markets. Low-cost indexed products are designed to provide a symmetrical return to the index. Symmetrical returns can look really good in a bull market as indexes climb, but expose investors to all of the market’s downside and loss in a bear market—losses usually large enough to drive them out of the market. Losing 50-60% of your money is indeed a steep price to pay for what looks to be low cost from a fee perspective. Active managers tend to have higher fees than passive funds, but our research indicates that when properly selected, active managers can provide after-fee outperformance across full market cycles versus passive alternatives.

How Financial Advisors Can Help

The role of financial advisors has evolved. Not long ago, creating a diversified portfolio that steadily grew was the value proposition. Advisors brought value to their clients by having access to information that the public didn’t and this information was the best way to navigate the markets. But with robo-advisors and low-fee trading programs, and the mass availability of information, this type of service provides little value today. An advisor can establish trusting relationships if they educate their clients on investment risks, manage expectations, and create a plan within the client’s risk tolerance that they can stick to and achieve their goals.

Advisors Need a Tangible Value Proposition

By moving beyond conventional low-cost passive portfolio concepts, financial advisors can build a tangible value proposition. When they help clients build portfolios by integrating better performing active managers with lower-cost index products, they can develop a risk profile that enables clients to comfortably hold portfolios through bull and bear markets.

In addition to building diversification, covariance, and non-correlation into portfolio modeling, we believe portfolios need to be anchored by active managers who have established management systems that actively manage risk to reduce loss. By raising cash, hedging, or both, active approaches can seek to protect a portfolio from large losses when the herd effect disables the normal risk reduction benefits of diversification. Our experience has shown that when clients are invested in portfolios that experience drawdowns within their risk tolerance, they are more likely to stick with their plan and achieve their wealth goals.

Fee pressure will likely cause clients to question advisors’ fees as they have manager fees. As this pressure increases, rationalizing fees will entail being able to demonstrate a combination of target risk and target return to customize portfolios to each client’s individual preference and need. Helping clients stay the course while generating the net returns required to achieve goals will be the holy grail of value-added financial advice in years to come. Financial advisors add value by providing advice and services that improve a client situation greater than the cost of service. It’s time to chart a new course and to let go of conventional investing wisdom that has failed investors in the past and is likely to do so again in the future.

Important Information

Past performance does not guarantee future results. Indices are unmanaged and may not be invested in directly.

The views presented are those of Don Schreiber, Jr. and should not be construed as investment advice. Don Schreiber or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.

ICI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any ICI data contained herein. This report is not approved, endorsed, reviewed, or produced by ICI.

You are not permitted to publish, transmit, or otherwise reproduce this information, in whole or in part, in any format to any third party without the express written consent of WBI Investments, Inc.

*Returns for average equity and fixed-income investors calculated by DALBAR. DALBAR uses data from the Investment Company Institute (ICI), Standard & Poor’s, Bloomberg Barclays Indices and proprietary sources to compare mutual fund investor returns to an appropriate set of benchmarks. The study utilizes mutual fund sales, redemptions and exchanges each month as the measure of investor behavior. These behaviors reflect the “average investor.” Based on this behavior, the analysis calculates the “average investor return” for various periods. These results are then compared to the returns of respective indexes. Ending values for the indexes and hypothetical equity and fixed-income investor investments are based on average annual total returns.


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Unless otherwise indicated all performance is sourced from Bloomberg.


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