Oh Behave!

I am often asked by prospects whether financial advisors add value? Being one, of course, I believe we add a great deal of value for our clients, in helping set and implement long-term financial goals, reviewing insurances and risk management strategies, being tax-efficient in all aspects of investing and estate/gift transfer issues, helping with education funding strategies, attempting to constantly reduce portfolio expenses, and much more.

But in many cases, and especially when the markets become increasingly unpredictable, our most valuable advice may simply be encouraging clients to follow good investment practices. This means keeping them from getting too swayed by momentary urges and making dramatic portfolio changes, usually based upon emotion (i.e. greed and fear), that they may regret later. Basically, our goal is to remove emotion and inject a bit of common sense when needed.

One of the foundational concepts that tries to quantify common sense is Modern Portfolio Theory (MPT), first discussed by Harry Markowitz when he was a doctoral candidate at the University of Chicago in 1952 (as an aside, I’m not sure how far we need to get from 1952 before we cannot continue to call something “modern”). MPT takes the dynamics of individual portfolio decisions (e.g. how much in stocks, bonds, etc.) and generates a continuum of investment options based on risk-tolerance. Typically called the “efficient frontier,” the continuum offers up portfolio allocations that aim to maximize expected return given a level of risk or, putting it another way, the lowest possible risk for a given level of return.MPT evolved and eventually engulfed other theorems, including the Efficient Market Hypothesis, which essentially translates into: markets reflect all information, trade at fair value, and the aggregate participants are rational.

Putting these together creates the following building blocks:

Investors are rational.
Markets are efficient.
Investors must take on more risk to generate more return.
Diversification (the use of uncorrelated or less correlated assets) reduces the risk of the overall portfolio.
Investors should build portfolios according to mean-variance theory.

Now, although a lot of that is true over extended periods of time, MPT tends to break down in the shorter-term and becomes (as described by our Chief Investment Officer, Dmitriy Katsnelson) “Modern Portfolio Realityin which:

Investors are not rational but could be considered “normal” (the definition of which is way beyond the scope of this missive).
Markets are not perfectly efficient.
Investors take on risk in the hopes of greater returns in areas not supported by fundamentals (e.g.cryptocurrencies, Beanie Babies, etc.).
Diversification breaks down when systematic risk alters correlations.
Investors design portfolios on the rules of behavioral theory.