The best portfolio is not necessarily the optimal portfolio.
As this thought-provoking article by Joachim Klement, CFA, highlights, “In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given investor. Or to recall a quote variously attributed to Albert Einstein, Yogi Berra, and Richard Feynman, among others: “In theory, there is no difference between theory and practice, while in practice there is.””
The article highlights the shortcomings of a portfolio optimisation approach. No surprises there!
Nevertheless, a key point made in the article is that many people in a Trustee or Fiduciary role see the portfolio optimisation process as a black-box exercise which is full of assumptions.
If true, this can be a challenge, particularly for those presenting the results and “the client never understands how these assumptions lead to the proposed allocation”.
I am sure this occurs to varying degrees and as a result there is a real risk that there is not a good understanding of the purpose of each investment allocation within the portfolio.
This often leads to the most pertinent point made in the article:
“But since clients do not grasp the purpose of each investment in the context of the overall portfolio, they are more likely to give up on the portfolio, or parts of it, in times of trouble. As a result, the best portfolio is not the optimal portfolio, but rather the one that the client can stick with through the market’s ups and downs. This means reframing the role of different asset classes or funds relative to the investor’s goals and sophistication rather than to volatility and return.”
Exactly. Reframing the role of the different asset classes can be achieved by taking the discussion away from the largely two-dimensional world of an optimal portfolio, market risk and return, and focusing instead on how the allocations will help meet a client’s investment goals over time.
Therefore, we can move beyond the Markowitz portfolio (the basis of Modern Portfolio and the “Optimal” Portfolio). This is not to diminish the Markowitz optimal portfolio and the benefits of diversification, the closest thing to a free lunch in investing. Markowitz also placed a number on risk through the variance of returns.
Nevertheless, variance of return may not be an appropriate measure of risk. Other measures of volatility can be used, just as more sophisticated portfolio optimisation approaches can be implemented. Neither of which would address the key issues of the article as outlined above. In fact, they may compound the issues, particularly the black-box nature of the process.
Other measures of risk should be considered, the most important risk being failure to meet one’s investment objectives.
If your investment goal is to optimise risk and return the “optimal” portfolio is likely to be the “best” portfolio. Albeit, I am not sure this is the primary objective for most individuals and companies. For example, other investment objectives may include liquidity, income/cashflow generation, endowments. (I also don’t think the most optimal equities portfolio is the best portfolio, there are other risks to consider e.g. liquidity and concentration risk which would mean moving away from the optimal portfolio.)
There are personal and aspiration risks to take into consideration e.g. ability to weather large loses. There could be investment goals with different time periods – the optimal portfolio is generally for a single period, not multi-periods.
This is not to say don’t use an optimisation approach, it is a good starting point. Albeit, the portfolio allocation will likely need to be adjusted to take into consideration a wider set of investment objectives, risk tolerances, and behavioural factors. I would have thought this is standard practice.
Expanding the discussion with the client will help identify a more robust portfolio and increase the understanding of the role of each allocation within the Portfolio.
In effect, a more customising investment solution will be generated, rather than a mass-produced product.
As noted in the article, reframing the role of different asset classes within a portfolio relative to the investor’s goals and the sophistication of the client rather than to volatility and return will likely result in better outcomes for clients.
Such an approach is consistent with Liability Driven Investment (LDI), where the liabilities are matched with predictable cashflows and the excess capital is invested in a growth/return seeking portfolio, which would include the likes of equities.
Such an approach is also consistent with a Goal Based Investing approach for individuals.
It is also more consistent with a behavioural bias approach.
As the paper concludes:
“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box “optimal portfolios.”
“Consultants, portfolio managers, and wealth managers who take their fiduciary duty seriously should seriously consider ditching their “optimal portfolios” in favor of these theoretically less optimal but practically more robust solutions.”
“Because you are not acting in the client’s best interest if you build them a portfolio that they won’t stick with over the long term.”
The above would resonate with most investment professionals I know, yet strangely it does not appear to be “conventional” wisdom. Perhaps ditch is to stronger a word, too provocative.
It would be hard to argue with implementing a more practical and robust solutions aligned with a wider set of investment objectives is not in the best interest of clients, particularly if they are able to stay with the investment strategy over the longer term.
Referenced in the article is the work undertaken by Ashvin Chhabra, Beyond Markowitz. This work is well worth reading. Essentially he frames the investor’s risks as being:
- Personal Risk – e.g. the risk of not losing too much that would impact on life style, this supports the safety first type portfolio
- Market Risk – e.g. risk within the investment
- Aspirational risk – e.g. taking risks to achieve a higher standard of living
This would is a great framework for a Wealth Management / Financial Planning process. Of note, market risk is only one component.
Lastly, the concept of a single Optimal Portfolio is far from the likely solution under this framework.
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