Post Modern Portfolio Theory (PMPT)

A new approach to guiding portfolios through storms in financial markets.

A brief history of navigation:
The magnetic compass was first invented by the Chinese in AD1080 but it was not used for navigation until AD 1111. Knowledge of the direction pointing North made it possible to estimate the direction one was heading. That was useful when a ship was leaving the harbor, but useless when one was out of sight of land. Until the 17th century sea captains relied on guesses about the currents, winds and speed to estimate their location. This was called, “dead reckoning”, probably because it often marked the crew for dead if the estimates proved wrong.
Due to coastal fog, many ships missed the harbor entrance to London and ended up on the rocks. This caused the King of England to offer the equivalent of a million dollars to the man who could solve the longitude problem. Everyone knew how to obtain their latitude, so knowing the longitude would fix their location where the two lines crossed. In 1736 an unknown amateur watch maker created a watch that solved the problem. Unfortunately, he lacked any formal training in watch making as well as any academic credentials, so his solution to the problem was blocked by the learned establishment for the rest of his life. The result was, John Harrison died a pauper and many lives were lost unnecessarily.
When I was in the U.S. Air Force, navigation training still began with dead reckoning and every flight plan began with estimates of the winds aloft, the lines of magnetic variation we would cross and our planned airspeed, all of which never proved correct. So the essence of navigation remained the same: determine your current location periodically and plot a new heading to your destination. It would have been unthinkable to “stay the course” in hopes that friendly winds would blow you back on course.
Portfolio navigation:
I believe the basics of navigation apply to portfolio management. If we view the client’s portfolio as a vehicle that needs to be navigated through financial markets, wouldn’t the return needed on the portfolio be akin to the heading the portfolio manager needs to steer in order to reach the planned destination? We call that heading the Desired Target Return® or DTR®. And if financial storms blew the portfolio off course, wouldn’t the ability to plot a new DTR to the desired destination be preferred to “staying the course?

This view challenges the basic assumptions about why people invest and how best to manage those investments. Portfolio Navigation assumes people are trying to get from where they are financially to where they need to be at some specified time in the future. More specifically, they want to reach a financial goal that provides a certain payoff that will achieve the goal. If a 401(k) investor wants to replace 70% of salary at retirement, doesn’t that define the goal and allow a reasonable estimate of where the portfolio needs to be in order to make that payout at retirement? Viewed as a navigation problem, would it make sense to put an investor in one portfolio until retirement and say, “just stay the course and maybe you’ll get there”? Only if one has no knowledge of portfolio navigation.

Just as the compass was the beginning of the science of navigation, Modern Portfolio Theory was the beginning of a new science of portfolio management. Portfolio Navigation provides a way to use the compass, along with the equivalence of longitude and innovations in equipment, to navigate the financial markets of the world and bring the portfolio safely to its desired destination. We hope this will prevent many portfolios from ending up on the rocks.

Here are two clips from e-mails I have received. The first is from a leading European University that teaches financial engineering. The second is from the prospectus of a fixed income mutual fund company. The first is a theoretical argument. The second is a CYA disclaimer statement.

Ever since the CAPM claimed that it was less risky to borrow money and invest it in the market portfolio than invest in a portfolio on the efficient frontier that lies below the security market line, both academics and practitioners have argued that leverage and going short are beneficial strategies for investors. Of course, the CAPM assumes there is such a thing as a risk-free rate and investors can lend and borrow at that rate, plus a few chapters of additional assumptions. Financial engineering is the latest development in this theoretically correct but practically wrong ruse. I am not opposed to the use of derivatives to alter the risk-return characteristics of portfolios but we need to keep in mind that engineers build real things and we build paper things that do not hold up unless a lot of assumptions prove to be correct. The misuse of financial instruments is not solely responsible for the financial collapse of 2008 but is certainly not blameless and does need to be regulated, not eliminated, to prevent future avoidable calamities.

I agree with professor Ducoulombier-investors should be fully informed of the risk-return characteristics of esoteric strategies. The investor should be entitled to the same disclosure protections by the SEC as the FDA provides to consumers of medications. For example:

1. The investor should be told the percentage of the portfolio in derivatives, the resulting leverage and the effect that could have on losses, fees and expenses.
2. An explanation of the assumptions being made should include examples of the consequences if those assumptions do not hold and a record of past occurrences.

“Order is indeed the dream of man, but chaos, which is only another word for dumb, blind, witless chance, is still the law of nature. You can plan all you want to but… “ Wallace Stegner

We are told that there is nothing to fear now. The fiscal cliff….a thing of the past. The sequester disaster….came and went. To paraphrase Stegner, never underestimate Govertment’s ability to make dumb, blind witless decisions that will upset the plans of learned men and women.

The flaws in our global financial system have not been corrected. That’s a shark that is still swimming out there in our sea of contentment. The promises of Governments, businesses and theories to transform our world of uncertainty into something we can count on have been proven unreliable. That pension benefit you were promised….here’s your 401(k), lots a luck. Remember this: we live in a world of uncertainty. There isn’t any knowing what is going to happen. But, there is a professional way to manage that uncertainty that might tilt the odds in your favor. That’s as good as it gets.

So, what are we professionals to do for those who put their trust in us? DON’T LET THEM SWIM WITH SHARKS! Make them stay in unleveraged shallow water. Don’t let them go beyond the diversified reef that provides some modicum of protection. Chasing the next Google will attract sharks.

Everyone knows the current value of their portfolio but not too many people know what the future value of their portfolio needs to be at some point in time in order to provide a desired payout. That is to say, they know where they are financially but they don’t know where they are going. What is worse, even if they do know where they are and where they are going they don’t know what direction to take to get to their financial destination. That is because one of the two investment frameworks available to them ignores any future payout that will be needed and both of them ignore the direction to their financial destination.
The most popular framework for investing is an asset management framework, e.g., the Capital Asset Pricing Model (CAPM). The basic assumptions of this framework are that future payouts are irrelevant, just make as much money as you can, given your tolerance for risk. Proponents of this framework almost always favor a heavy allocation to equities. The other framework views future payouts as liabilities and therefore uses liability driven investment strategies (LDI). This framework is almost always invested heavily in fixed income securities no matter where interest rates are.
Both of these frameworks ignore the return one needs to earn on the assets in order to achieve the future payouts. That needed return is the direction the portfolio needs to take and we call it the Desired Target Return® or DTR®. To illustrate the importance of the DTR, assume you want to send a valuable package to New York. Asset Management advocates don’t care where you are sending it from or where you want it to go. They assume you want to send it as far as possible as fast as they can. LDI proponents put all packages on a truck no matter how far it needs to go or when it needs to get there. Neither one bothers to determine the direction to send it, due to their myopic concern about which vehicle to choose.
We believe you are trying to transport your portfolio from where it is to where it needs to be at some specific time in the future in order for you to use its contents as a cash outflow. That is why we use Post Modern Portfolio Theory to construct a portfolio with the right combination of investment vehicles and manage it afterward using Portfolio Navigation to change direction when it gets blown off course. That’s why we say:

Oh, I almost forgot. There is one other framework that claims all they need to know is your age in order to determine what vehicle to put your valuable package on. They also neglect to determine what direction to take.

Outlook for 2013

Worried about falling off the fiscal cliff?  I would like to recommend a book for you to start out the New Year.  It is “Abundance.”  The authors point out that we have evolved to be acutely aware of potential dangers to the point that we literally shut off our ability to take in good news.  The mass media feeds on our insatiable quest for scary information because that is what sells advertising space.  The facts, as they present them are: we are better off than we have ever been in the history of mankind.  Don’t believe it?  Read the book.

The most important phrase in the book to me was, “We need to understand the way our brain shapes our beliefs and our beliefs shape our reality.”  This is the message that behavioral finance is trying to bring us and it is an important piece of the puzzle we are trying to solve.

A look back with regret

Given my understanding that the investment community does not like dramatic change, but will tolerate small incremental changes, I have presented PMPT as a modest change to MPT.  It is not.  I even claimed that DTR® is simply an internal rate of return that any hand held calculator could produce.  Sorry, to say that it is similar is a stretch.  I knew what I wanted it to be but it took my colleague, Dr. Hal Forsey, to work out the mathematics correctly.  My excuse was that I wanted people to focus on the importance of the concept and not the complexity of the mathematics. Mea culpa, mea culpa, mea maxima culpa!  HAPPY NEW YEAR!

Much attention has been given to the matter of the proper glidepath for 401(k) participants.  Most recently Rob Arnott, founder of Research Affiliates, has weighed in on this subject.  Arnott’s criticism of any mechanistic glidepath,[1] was in turn criticized by Steven Wallman[2] for missing the point that a glidepath reduces risk.   Arnott then accused Wallman of missing the point because “the numbers are what they are” and the numbers show a reduction in return that offsets the reduction in risk.  Well, Arnotts contrived numbers may show that but in my opinion, they are both missing the point.  To paraphrase Einstein, they are trying to solve today’s problems with outmoded methodologies of the past.

The main flaw in their logic is that both of them choose to ignore the return that each 401(k) participant needs to earn on their assets in order to meet a future payout, namely, retirement income. Both gentlemen choose not to estimate this return that we call the Desired Target Return® or DTR®.  Ipso facto, ignoring the DTR makes it impossible to calculate the risk of falling below the DTR or the potential to exceed that return.  In other words, they have identified the wrong problem which leads to the wrong solution to the real problem.

Framing portfolio management as an asset management problem leads both men to focus on which assets to use to achieve the highest terminal wealth.  Wallman says young people should start out with stocks and end up in bonds to reduce the risk of a hit to terminal wealth.  Arnott says investors would more often have ended up with greater wealth if they started out with bonds and ended up in stocks.  We agree with Wallman that 401(k) participants who wanted to retire in 2008 should not have been heavily weighted in stocks in 2007.  We also agree with Arnott that age alone should not determine the asset allocation between stocks and bonds and starting to decrease equity 20 years before retirement is ridiculous.

But gentlemen, investing is an asset-liability management problem, not an asset management problem.  Stocks and bonds are only the vehicles we use to get investors from where they are financially to where they need to be at some point in the future.  Your argument is as foolish as debating whether or not people should begin every trip by air or by bus.  The proper combination and timing of vehicles depends on where they are going and where they are starting from, not on their age or their preferences.

Lest we be misunderstood, we have the greatest respect for Rob Arnott and his understanding of financial theory.  He was, after all, the editor of the Financial Analysts Journal.  But let’s see how his adherence to the MPT framework leads him astray as regards a much needed solution to managing 401(k) plans for participants.

Critique:

1. Arnott uses 141 years of stock and bond market returns to make the case that “Prudent Polly”, who begins at 22 years of age with an 80% equity position and at age 30 begins her descent in equity until age 63, at which time, she liquidates her portfolio and purchases an annuity with the funds she has accumulated.  With 20/20 hindsight he shows she could have done better by maintaining a 50/50 mix of stocks and bonds or steadily increasing equity exposure.  This implies history is going to repeat itself, an assumption he later decries.  We believe Bradley Efron’s “Bootstrap” procedure is a superior way to describe future return distributions and provide evidence in our paper titled, “Portfolio Navigation”  that a glidepath longer than five years is like starting your descent into Kennedy Airport when you are over Chicago.
2.  Arnott uses three measures of risk to make his point: the standard deviation of returns for the past 141 years, the range of returns from the 10^th percentile to the 90^th percentile and the ratio between the 10^th and the 90^th percentiles.  However, none of these risk measures incorporate the return Polly needs to earn in order to replace a predetermined percentage of salary. Furthermore, we have shown that reliance on the probability of a low return for capturing the risk that Polly is facing is inadequate and misleading.[3]  The disastrous results of using Value at Risk (VAR) in 2008 testify to that.   We believe a relevant measure of risk should capture the risk of not achieving the retirement income she needs and propose deviations below her DTR as a more appropriate risk measure.
3. Arnott then says it is much more important for Polly to know “how large a lifetime inflation-indexed annuity she can buy at retirement” because that is “an important measure of success.”  In other words, Polly is stuck with whatever amount of money she is lucky or unlucky enough to accumulate at retirement, because nobody bothered to estimate how much she would need to replace, say, 70% of her salary at retirement.  This implies the goal is to make as much money as she can.  We believe the goal is to replace 70% or more of her income and the way to measure that is to estimate the potential to exceed her DTR.
4. Arnott then calls attention to his assumption that she was only saving $1000 per year and nothing can make up for investing too little too late.  We agree, but believe an appropriate methodology would notify her periodically how much more she needs to invest, as we do in our Mapvest^® report.
5. Arnott then attempts to correct for assuming the past is prologue by randomly drawing annual returns from the 141 years of annual returns to generate a better picture of uncertainty.  However, first he attempts to make the outcomes look more like today’s by assuming “ risk in the future resembles the past but returns in the future are lower.”  This ad hoc adjustment seems to imply his methodology is flawed. Furthermore, only selecting annual returns that did happen cannot account for what has never yet happened.  But the bootstrap procedure does address this without subjective adjustments.  We believe the methodology we used in our paper “Portfolio Navigation™” is a superior way to compare strategies and leads to a more reliable way to manage Polly’s portfolio over time.

Summary and conclusions:

Instead of framing portfolio management as an asset management problem where the solution is to maximize wealth and whoever makes the most money wins, we believe one should frame it as an asset-liability management problem.  From this perspective, the solution more closely resembles a navigation problem that will transport Polly’s portfolio from where it is to where it needs to be at some specified time in order to meet or exceed an estimated payout schedule.

Bickering over trivial matters like the glidepath only serves to obscure the real problem.  Target date funds are a dismal failure, yet the most popular choice for defined contribution plans.  Therefore, instead of trying to fix a seriously flawed methodology, we should all work to scrap it for a superior approach oriented toward accomplishing the investor’s real goal of replacing income at retirement.  Making money is not the goal in and of itself.  Making money is how one accomplishes the goal of meeting or exceeding some specified future payout. How much money is needed and how much risk is involved can only be determined if one bothers to estimate the DTR. This is a critical variable that should no longer be ignored.

President Truman once asked to be sent a one armed economist to express his frustration with those who said, “On the one hand things could go like this but on the other hand they could go like that.”  It is shocking how many people think that was a wise statement.  If he would have asked for the probabilities for each possible outcome, that would have been wise.  In today’s world of PMPT even that would fall short of being wise.

This highlights a serious problem in our efforts to help people invest wisely.  They don’t want to be told the economy might go in the toilet but on the other hand the stock market might go up 20% or more.  The talking heads on television shout about the pending disaster as we approach the fiscal cliff, because fear sells commercials better than hope.  However, this emotionally driven approach is supported by well reasoned economists like John Taylor at Stanford.  On the other hand, Scott Minerd at Guggenheim also provides a well reasoned analysis of the same data and recommends investing in stocks and real estate as a hedge against inflation.

Unfortunately, Most clients are not trained to think probabilistically. They want us to take one side or the other.  They don’t ask for our assessment of the probability that John Taylor or Scott Minerd is right.  They take the attitude that, “If you don’t know, then my guess is as good as yours.” What I would like to say to them is: “Let’s also consider the downside risk if Taylor is right versus the upside potential if Scott is right.  And let’s consider other scenarios that are also possible,” which is the approach I suggested  back in 1990 when I wrote “The Look of Uncertainty” in Investing magazine.

Yes, that’s asking a lot. And yet, most people who eschew statistics will ask their doctor, “What are the chances of living if I undergo surgery and how much pain will I suffer for how long?  I have noticed that every physician’s office I have visited has charts on the wall depicting the various body parts that they specialize in with the medical terms for each part.  They use this to talk to me about what is going on in my body and what I should do about it.  I believe we financial professionals should use statistical pictures in the same manner and talk to clients about what is going on in their portfolio and what should be done about it.

The key pad is mightier than the pen. 

Because we don’t know what is going to happen in a world of uncertainty we make assumptions.  That is reasonable and rational behavior.  Then we start treating those assumptions like facts and therein lies the problem.

President Obama has just signed the Highway Investment, Job Creation and Economic Growth Act of 2012 that will increase corporate earnings, increase taxes and decrease pension liabilities.  All this, with a stroke of the pen that simply changed the assumed discount rate from 2.56%  to 5.59%.  Another short term fix to a long term problem.

What this points out to me is the fallacy of using an assumed rate to determine how to properly manage a pension plan.  The actuary uses a highly sophisticated computer program to solve for the liability stream of payouts for the next 30 years or so.  The present value of the assets is known with certainty…well, excluding the illiquid assets lurking in the portfolio.   

What pension plan sponsors should demand is that actuaries SOLVE for the internal rate of return (IRR) that discounts the expected payouts to the present value of the assets.  This would be a meaningful number that would allow the plan sponsor to use a more realistic estimate of the rate of return needed in order to meet the projected liabilities.  Actuaries can do this with a stroke of the key pad on their computer and that will be an antidote to the illusion that the pension plan is funded when it is not.  It will also allow the consultant to measure risk relative to that IRR instead of to some market index that is totally unrelated to the liabilities.