There is a better way to build investment portfolios than the methods presently employed by most investors and advisors. Perhaps that is hard to imagine seeing as how well we have been served by Modern Portfolio Fallacies and the Efficient Market Hypocrisies, but if you have an open mind, there is a strong chance that these portfolio construction principles will resonate with you, particularly on the heels of what we have learned from the half dozen market meltdowns experienced since 1987.
I know that the idea of a new asset-allocation model is intuitively tiresome, but if there was ever a time to revisit the prevailing conventional wisdom, it is now. This smarter portfolio approach places heavy emphasis on safety of principal, liquidity, and income, yet simultaneously provides investors with compelling potential for capital appreciation.
I refer to it as Hybrid Portfolio Theory (HPT), in which the investor allocates into two distinct (hybrid) portfolios. The larger portfolio (A) represents 75% to 90% of the assets and is invested with the primary objective of liquidity, safety of principal, and income. This portfolio is benchmarked against a blend of risk-free and short-term-yield rates and invests predominantly in money markets, CDs, short-term munis, and Treasuries.
The challenge of portfolio A is to maximize yield in basis points and increase yield to the point that does not threaten the overall liquidity and safety of principal. With liquidity and safety of principal as primary objectives, that effectively eliminates allocations to high-yield corporate and junk bonds, REITs, MLPs, closed-end and utility stocks by the literal-minded HPT practitioner.
Why Bother with Stocks?
So what is the source of return for capital appreciation in HPT? Not traditional equities. Stocks go up and stocks go down. That’s a symmetrical outcome that we now know empirically to be a bad bet unless you have a multi-decade investment horizon. Rob Arnott’s “Bonds: Why Bother?” in the May-June 2009 Journal of Indices emphatically settled the score.
Arnott proved that the 5% risk premium promoted by the financial services industry is at best unreliable and is probably little more than an urban legend. Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beats the S&P 500 through January 2009. Going back 40 years to 1969, the 20-year bond investor still outperforms by a marginal amount, even with the Carter-era inflation and traumatic bond market in the ’70s.
It is not debatable. Equities have not delivered their risk premium and are simply not worth their risk. Rather than pursing the laughably unreliable risk premium of equities, Portfolio B is exclusively seeking higher risk-higher return positive asymmetric outcomes (PAO). The Portfolio B benchmark return is in the 10% to 20% range.
A PAO is defined by its ability to generate high double-digit or multiples of return on investment, as can be achieved by successful investments in venture capital, private equity, direct (angel) private investment in startups, small business, private manufacturing business, private real estate, private debt, franchises, operating cash-flow businesses, as well as publicly traded emerging growth companies and leveraged option strategies or highly specialized investment strategies such as managed futures.
The PAO mandate is broad but should ultimately be defined by a positively skewed risk-reward ratio, as well as the practitioner’s sector expertise and due diligence resources.
The investor’s overall hybrid portfolio benefits by assuring that the vast majority of assets are not exposed to a downright bad wager relative to risk-free or short-term assets, as well as unpredictable (yet, frequent) black swan events that devastate investor portfolios.
Hybrid Portfolio Theory should be implemented as a theory, not as an absolute rigid asset-allocation model. If the portfolio manager, advisor, or investor accepts that: 1) current asset-allocation frameworks cannot successfully mitigate significant market exposure and do little to protect investors from unpredictable negative black swans; 2) investors are generally over-exposed to equities in light of the proven absence of any sustainable risk premium; and 3) investors benefit from limited but diversified exposure to investments and strategies characterized by the possibility of positive asymmetric outcomes.
This is a portfolio theory that you can adapt into your other core asset-allocation principles and values, and use as well to differentiate yourself while building your practice for the high-net-worth. I welcome the chance to explore this further with you.