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Portfolio > Portfolio Construction

Modern Portfolio Theory Gives False Confidence, Longtime Advisor Says

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The asset garden approach to asset allocation is intuitive, allows for creative freedom and, unlike Modern Portfolio Theory, does not give investors “a false sense of confidence” about portfolio outcomes. So argues former money manager J. David Stein, host of the popular podcast “Money for the Rest of Us,” in an interview with ThinkAdvisor.

The asset garden methodology of “landscaping” an investment portfolio encourages investors to understand what drives an asset class rather than get “bogged down” in MPT, maintains Stein, who was chief investment strategist, chief portfolio strategist and research co-head at Fund Evaluation Group, a $70 billion investment advisory firm that he co-founded.

An institutional advisor for more than 20 years, Stein, 54, likens asset-garden allocation, which he uses for his personal portfolio, to designing a garden with a variety of plants and flowers that bloom at different times. Just as there can be no “optimized flower garden,” there is no “optimal” portfolio, he contends.

In his new book, “Money for the Rest of Us: 10 Questions to Master Successful Investing” (McGraw Hill-Oct. 2019), he provides a detailed framework for analyzing investments and evaluating opportunities.

In the interview, Stein, who became a podcaster about six years ago after selling his interest in Fund Evaluation to his partners, explains his “leading-edge-of-the-present” approach to investing and discusses six of his book’s 10 questions including: Is it investing, speculating or gambling? Who is getting a cut? How does it impact your portfolio?

ThinkAdvisor recently chatted with Stein, who was on the phone from his Phoenix office. A longtime public speaker who has addressed industry events held by Morningstar and TD Ameritrade, among others, he talked about the array of asset classes in his own portfolio and why his approach to investing focuses on the present rather than forecasting the future.

Here are excerpts from our conversation:

THINKADVISOR: What’s your approach to investing?

DAVID STEIN: I call it investing on the leading edge of the present: Where are we today? What are the high-probability decisions we can make that will help us navigate the uncertainty and complexity of the investment landscape?

Please elaborate.

My approach is to try not to forecast the future but to be mindful of the present and willing to make asset-allocation adjustments based on market conditions — for example, when there’s a major regime change or the risk of that is high, to be willing to adjust the allocation to reduce risk.

One of your 10 questions is to ask: Is what you’re considering investing, speculating or gambling? Please explain the main differences.

With an investment, there’s a reasonable expectation that the return will be positive. There’s a cash-flow component, a dividend yield, interest. Speculation is where there’s disagreement regarding whether the return will be positive or not, particularly because there’s no cash flow. There’s no income stream associated with it. The only way you’ll make money is if it goes up in price. Speculation includes antiques, art work, gold coin.

And gambling?

A gamble is something with a negative expected return that you do to be entertained: a lottery ticket is a gamble, going to a casino is a gamble. There are investments that are tricked-up gambles, such as binary options.

Discussing the question, “How does it impact your portfolio?” you write, “Asset allocation based on Modern Portfolio Theory can give you a false sense of confidence regarding outcomes.” Why?

Invariably it focuses on the expected return as opposed to the range of return, which tends to be ignored. You end up with nested assumptions, and at the end of the day, you get a model — investors become very confident that this is their expected return. They don’t really dig into the assumptions that led to that.

What should you be determining, then?

If we understand what the drivers of an asset class are, the reasonable return, the downside, we can add it to our portfolio without spending a whole lot of time figuring out its correlation to everything else [as with MPT]. We need to just understand if it’s more stock-like, more bond-like or a hybrid, and then add it and see how it behaves.

Please explain your asset allocation strategy.

I call it the asset-garden approach. One of the problems with Modern Portfolio Theory is that we think we’re trying to find the “optimal” portfolio. If instead, you approach asset allocation like landscaping, [the analogy is that] there isn’t a correct “optimal” flower garden: You have a variety of plants, some in the shade, some in the sun. The temperature is different in various places. You have principles of design, but [overall] it’s an intuitive approach.

And with the asset-garden methodology?

Like landscaping, there are rules of thumb, but there’s freedom to create and build the portfolio. And it’s much easier to make changes.

In your own portfolio, in addition to equities and bonds, you have REITs, MLPs, private real estate, unsecured lending, art and antiques, gold and cryptocurrencies — all in all, a dozen-plus asset classes. Why such a big variety?

That’s, sort of, the point: to get as many different return drivers as you can because you don’t know exactly how things are going to turn out. Many asset classes go down together. So let’s ignore correlation and just assume they’re going to go down together, in which case, we can do a weighted average expected return based on reasonable assumptions and then do a weighted average of the worst-case scenario and figure out what the downside is.

But before determining the downside, I assume you should ask: What is the upside? 

Yes. That’s understanding what drives the return, what’s the expected return of the particular investment you’re considering. An example of that is when you invest in stocks. The expected return for bonds is highly predictable. So it’s understanding those drivers and making plans based on reasonable assumptions [according to] where we are today.

Then the next question to ask, logically, is: What is the downside?

That’s looking at the worst-case scenario. That a stock will go up is factored in. What we care about [determining] is the maximum draw-down. What’s the worst-case potential loss for an investment, and what would be the personal financial harm from that loss? For example, if I put half my money in stocks and expect a 30% drawdown at some point, it may take four to five years to recover. So how would that impact my lifestyle?

Then there’s the question: Who’s getting a cut? Do you think financial advisors earn their cuts?

I do. But one of the challenges the industry has is that in order for advisors to be profitable, their fees have to be high. The fee needs to be 1% in order to be able to provide that level of service, and that 1% ends up coming out of the return. I think advisors earn their money, but the challenge is that many individuals haven’t saved enough to be able to afford to pay an advisor on an ongoing basis. So many just work with an advisor to get their financial plan and then implement it on their own.

Broadly, what’s the best reason to hire an FA?

You don’t hire an advisor because you think they’re going to outperform the market — that they’re better at stock-picking. You hire an advisor for peace of mind, to provide help with your financial planning needs or your retirement planning. An advisor keeps you from doing stupid things in your portfolio. They’re there to do some hand-holding and provide guidance.

What about relying on them to recommend investment decisions?

You don’t necessarily hire an advisor because you think they’re a brilliant investor. They’re probably a good investor, but they’re not going to outperform the market. If they were a brilliant investor, they would be running a hedge fund — they wouldn’t be working with individuals in an advisory capacity.

What’s your forecast for the market in 2020?

I don’t make one-year predictions for the stock market. Right now, overall conditions are kind of low-neutral. The economy had been falling globally, but it started to pick up a little bit. Investors have been very bearish. A recession was supposedly coming: [Many worried] that in the U.S., things were falling off a cliff — but they’re still not. There’s a difference between an economy slowing its growth rate and the economy contracting, which is a recession. With my models, we’re about 10% underweight our long-term target, which is where you want to be in a low-neutral investing environment.

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