It’s Time to Throw Out Everything You Know about Portfolio Construction
Evolution benefits those who are adaptive to change. The financial services industry is littered with the remains of once-successful wealth management firms that couldn’t grasp this concept. Many of them expired in 2008. Several more went down during the pandemic. Economics played a small part in both. Resistance to change dealt the killing blow.
Success in finance is measured by returns. Clients typically stay with their advisor when they see consistent gains and leave when they experience losses. It’s a predictive behavior that’s been prevalent in our industry since it first began. Remaining in the black is where the challenge lies. Advisors who evolve their approach when it’s called for can do that. Others fail.
The crux of the problem is in how we’ve been taught to manage money. Traditional portfolio construction and “modern” portfolio theory don’t work in a 21st-century, post-pandemic stock market. What we experienced two years ago was a reset, so historical market movement is no longer relevant. Proving that is a simple matter of reviewing our history.
John Burr Williams and “The Theory of Investment Value”
The most popular belief about the Great Depression is that it was caused by the 1929 stock market crash. That’s a result, not a reason. The primary activity that led to the crash was the panic selling of overvalued stocks. That was followed by a loss of confidence in bank solvency, credit defaults, and fifteen million unemployed Americans.
Speculation in the “Roaring Twenties” enticed millions of people to tap their savings or borrow money to buy stocks. The Federal Reserve Bank, to slow down consumer spending, raised the federal funds rate to 6%. It did not have the desired effect. The country went into a recession, and funding sources started to dry up. That all happened before 1929.
In 1938, three years before the Great Depression officially ended, an American economist named John Burr Williams published a book called “The Theory of Investment Value.” It introduced the dividend discount model (DDM) to more accurately value stocks by taking the sum of all future dividend payments and discounting them back to their present value.
William’s work was groundbreaking at the time because it broke the “casino mentality” that had corrupted the stock market in the 1920s. It also set the table for the discounted cash flow valuation method that is still used today. As for portfolio construction, DDM is a reminder that accurate values are more relevant than speculated prices that can be overinflated.
Harry Markowitz and “Modern” Portfolio Theory
Sorry to rain on your parade. Nothing written in 1952 can be considered “modern” in 2022. Harry Markowitz introduced the concept of investor risk tolerance when he published “Portfolio Selection” seventy years ago. It took nearly a decade for it to become popular, but it eventually became the foundation for portfolio construction in the 20th Century.
Note that we did not include the past two decades in that statement. Modern Portfolio Theory (MPT) worked prior to 2001. Aside from the Black Monday Crash of 1987, the market stayed consistent after World War II. Investors enjoyed an average return of roughly 10% on the S&P 500. MPT relies on that because part of the theory is return percentages level out over time.
Fast forward to the present millennium. We’ve experienced 9/11, the financial crash of 2008, and most recently, the 2020 Covid-19 pandemic. S&P returns for the past twenty years are just 8.91%. Adjust that number for inflation, and it plummets to 6.40%. The Social Security Administration predicts a 9.6% cost of living increase in 2023.
Using MPT to build risk-based passive investment portfolios in this climate is a recipe for losses, not a path to financial gains for your clients. Mathematically, the odds of us getting through the next twenty years without another “black swan” event are not in our favor, so historical returns from the last century are no longer valid. It’s time for portfolio construction to evolve.
Risk, Rewards, and DCF Valuation
We’re going to go out on a limb here and say that the 1938 work of John Burr Williams is more important to us right now than the iconic 1952 classic by Harry Markowitz. Historical performance is skewed by overvaluation. If you use the market cap to GDP ratio, you’ll find that the 2022 stock market, in general, is overvalued by 77%. That distorts risk assessment.
Using dynamic valuation methods like discounted cash flows (DCF) or EBITDA comparison will give you a more accurate picture of a company’s worth than simply tracking share prices or P/E ratios. With an overvalued market, pricing is speculative, not actual. Calculating actual value before adding a holding to your portfolio could help you withstand market corrections.
Safeguards have been put in place to help us avoid another Great Depression, including “circuit breakers” that were added in 1987 to prevent a massive selloff. That doesn’t mean we won’t see losses. With MPT portfolio construction, holdings are expected to rebound over time. That’s not guaranteed. Many advisors are turning to active portfolio management to mitigate losses.
Our Solution: Tactical Portfolios and Active Trading
Harry Markowitz was a 25-year-old grad student when he published “Portfolio Selection.” You may have someone just like him interning at your office. His original work contained ten pages of charts and graphs and only four pages of actual content because he never meant for it to be a comprehensive work. He was simply proving a mathematical theorem.
John Burr Williams was a seasoned economist when he produced “The Theory of Investment Value.” His goal was to find a way to avoid investing in overvalued stocks because he saw first-hand what the result of that was. Unlike Markowitz, whose work wasn’t noticed for ten years, Williams came up with a timely concept for a market that desperately needed it.
We’re not advocating one portfolio construction over the other. Risk tolerance is an important concept. Managing risk by spreading it across all eleven market sectors is not going to work in 2022. We prefer actively managed tactical portfolios that contain accurately valued stocks, ETFs, and alternatives in solid growth markets. We call that combination “Tactive Investing.”
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