A Modern Theory on Portfolios
Harry Markowitz’s Influence on Robo-Investing
Nobel Prize in Economics
In 1952, Harry Markowitz would publish a paper that would change the face of investing for decades. In fact, his paper resulted in The Royal Swedish Academy of Sciences awarding Markowitz the 1990 Nobel Prize in Economics. The Royal Swedish Academy of Sciences explains Markowitz’s contribution as someone “who developed a theory for households’ and firms’ allocation of financial assets under uncertainty, the so-called theory of portfolio choice. This theory analyzes how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced.”(Nobel Media: Press Release, 1990).
Since his revolutionary paper and subsequent Nobel Prize, the investing world took notice. Many investors utilized the formulas provided in his “Portfolio Selection”, most notably automated or robo advisors. Some of the largest robo advisors, such as Wealthfront (Wealthfront Methodology, 2018), Betterment (Betterment Portfolio, 2018), and Acorns (Acorns Invest, 2018) utilize the so-called Modern Portfolio Method to some degree, sometimes as the sole source. This level of dependency with what amounts to a massive amount of capital should be scrutinized and changed to better mitigate uncertainty in investing. This has happened to a degree with the ideas of rebalancing and tax-loss harvesting. Both these alterations aim to maximize overall profits and minimize taxes for an individual, taxable account. The usefulness of Modern Portfolio Method diminishes the further you get from an individual taxable account.
Modern Portfolio Method Explained
So what is the Modern Portfolio Method and how did it become the global gold standard for investing? “In no case is a diversified portfolio preferred to all non-diversified portfolios” (Markowitz, 1952) of course with the assumption that short selling is not applied. In his paper Portfolio Selection, Markowitz goes through multiple complex formulas and calculus to determine an ideal way to identify securities to buy/sell. The reason short selling is exempt is that using the formula would suggest buying as much as possible in the largest securities.
The old saying goes “it’s not timing the market, it’s the time in the market.” Markowitz understood this and the fact that American markets historically grow over time. Markowitz also followed the basic advice of diversification to mitigate uncertainty. When devising his paper, he leaned on these lessons and formulated that a diversified portfolio if left alone over a large period of time, would not only beat inflation but also provide a nice profit past traditional savings accounts.
In order to execute this idea effectively, Markowitz created a series of formulas that identified different securities that seem stable enough to provide a consistent, small profit over time. When automated advisors ask which risk tolerance you would like, it is altering the formula presented by Markowitz to potentially include some high-growth securities. While there will never be a way to truly eliminate uncertainty in the market, different theories and methods will constantly attempt to find the best way to spend trillions in the economy. With the onset of AI and computing as a whole, investing has relied on the models, formulas, and algorithms it produces to decide where funds go. Harry Markowitz simply thought of a formula for computers to compute on a large scale without any human input.
Automated or robo advisors like this because it relieves the staff from having to constantly be monitoring a customer’s account, or active investing. These services do exist, however often come at a high cost. Automated advisors cost very little in relation, with even the highest being lower than any reputable active investor. Another old saying that is relevant here is “you get what you pay for.” The upsides are very low if any barrier to entry, with many automated advisors having a $0 minimum, as well as sleek user interfaces and mobile compatibility. This allows you to interact with your invested funds at any time, at any place. Beyond the emotional reaction some have when monitoring their own investments they can’t control, this is the goal of passive investing. In theory, the investor put money in, the computer figures out where to put it, and lets it sit until the investor decides to move it out (or sell their position).
Terms
The world of investing is full of complicated jargon and outdated terms that turn many people off from the idea of actively managing a portfolio, no matter the size. For the Modern Portfolio Method, the initial look seems foreign, complicated formulas, old language (the paper was written in the 50’s after all), and overall lack of a conclusion. For the purposes of this article, Modern Portfolio Method, Modern Portfolio Theory, and Portfolio Selection will be used interchangeably. This is because the original paper, Portfolio Selection, was later branded the Modern Portfolio Method, but also remains a theory.
Some investing terms that are important to know are capital gains, which is the amount you make in the stock market over your initial deposit (also called principle). An asset or security is another name for a share of a company, security is the official term since the value can make the share a liability, but asset if often used in a hopeful sense. Diversification happens when you spread out capital (money you are investing) into multiple companies. This makes the loss or gain of a particular security less impactful on your portfolio’s (a name for all of a person’s shares) overall performance.
In addition, many different types of accounts exist for the purpose of investing, depending on the desired outcome. For most utilizing the Modern Portfolio Method, the taxable account is most logical. This means any capital gains are taxed (the amount of time you owned a share decides the rate), and must be accounted for on the years’ taxes. This is also useful for a technique called tax-loss harvesting. Since you can write off a portion of losses on your taxes, tax-loss harvesting aims to have a small group of stocks lower in value to offset larger gains in other stocks. This practice is risky, however it has the potential to significantly reduce your tax bill come tax season.
There are also different types of investors. Institutional investors act on behalf of large corporations to invest in the stock market. Some companies utilize this as a source of income, and others as a safety net to use in the case of less than stellar results in a given quarter. The other type of investor is the individual, split into taxable and retirement accounts. Taxes for each of these groups are different, as well as the overall power they tend to wield over a company. An automated advisor (advisor being someone to help navigate the investing waters) is a computerized, often online, resource that is a good resource for some in the individual category. Individuals also tend to have more freedom with buying and selling shares since the few shares they own entering the market would not drastically change the price. Large, institutional investors are often carefully regulated to ensure no great false inflation (raising stock price) or deflation (lowering stock price) happens when they buy or sell a company’s shares. Since shareholders are the owners of a company, the more shares owned, the more power is granted.
Investing Uncertainty
First, the elephant in the room. No investing strategy is immune to uncertainty and those participating in investing should expect to see times of downturn as well as upturn. Given we are in the information age and have a vast set of knowledge, technology, and resources in the palm of our hand, it should be off-putting that the global gold standard for what amounts to trillions of dollars relies on theory and formula devised in the ’50s. The same cannot be said for actively managed portfolios since decades of research and experience has refined their thinking to best adapt to market uncertainty.
Humans are by nature an emotional species. In investing, uncertainty causes fear when the markets are down, and greed when the markets are up. This, in turn, goes against the advice of “buy low, sell high.” When fear is rampant, it is reflected in the market, downturns, recessions, corrections, and a whole lot of red fills the screen, hence the affectionate nickname a “bloodbath.” On the other side, if particular security is rising rapidly, people may let greed rule their purchase by not conducting adequate research, simply seeing a spike and wanting in on the action. A great example of this is with Bitcoin during the spike of December 2017, where new investors flooded the market wanting a piece of its meteoric rise. However, as many learned in January of 2018, reacting to the market based on emotion is a recipe for disaster.
Active v. Passive
Active investing is the type of investing that has always been around on the New York Stock Exchange (the United State’s largest exchange). Though this can take many forms they all accomplish the same result. Be it on the floor in Wall St. or the local branch of a bank, or now online from the comfort of home, investing actively involves the direct sale of individual stocks. On occasion, fractional (a part of a share) shares and pink sheets (penny stocks too low to be listed) may be traded, but mainly the exchange of full shares is what drives markets.
An industry name for the amount a security rises or falls in a short period of time is called volatility. This measure is used by investors to determine when to enter the market. If a security is very volatile (meaning large changes over a short period of time) it may be smart to time entry correctly or look for a safer security. Active investing provides this data and allows an individual or their advisor the chance to react and buy/sell/hold. This gives the individual or the advisor of their choosing greater control over the capital currently in the market as well as company leadership in the form of stockholders meetings and critical votes sent out periodically.
Passive investing, in contrast, is the act of depositing money in an account that aims to achieve modest returns in exchange for a fee, often a percentage of the total account value. While there are a few brokerages with zero fees for active investing, none exist for passive. The value added is the amount of time needed to research and follow the stock market and economic trends is greatly decreased. Since many passive investors are maintaining relatively small accounts, fractional shares and price delays are relatively common. The use of Exchange Traded Funds (ETF’s) furthers this by splitting capital between ETF’s that are themselves made up of portions of other stocks, often from a particular industry or target (i.e. dividends, year over year growth, etc.).
The Modern Portfolio Method utilizes a form of passive investing by diversifying and holding, in the hope that markets and the particular securities selected continue to rise as a relatively consistent rate. The method does utilize rebalancing as a way to limit overexposure to high growth or high loss security. Rebalancing happens when particular security in the group begins to become an outlier in growth or loss, and thus a passive investing system based off the Modern Portfolio Method would react by buying/selling to maintain a steady return. Often, when this happens, cash is temporarily held as a safe asset in the case of rapid correction of a price.
Feasibility of Automation
The Modern Portfolio Method did get a few things right, small scale investors do not want to spend a large amount of time researching stocks, the market, and economic and governmental policy for what amounts to a few dollars per month. In addition, the inclusion of rebalancing and tax-loss harvesting is an important element that can drastically affect returns the larger an account becomes. What it did not is fundamental that a chosen, low uncertainty and high dividend group of securities will always remain that way. Even with rebalancing, it only takes a few securities going sour before advisors again have to tweak the algorithm. In addition, more and more investors are becoming socially conscious, caring less about a minuscule raise in returns and more about supporting the companies that align with their values. Some passive firms such as WealthSimple attempt to cater to this crowd by having a “socially responsible” portfolio option as well as a “halal investing” portfolio which adheres to strict religious guidelines when it comes to investing.
Ultimately, as long as the markets continue to be dominated by uncertainty and the actions of human emotion and hope, artificial intelligence and the like will not be able to accurately play the market for maximum returns. Automation requires data to be input, which includes current data (sometimes up to the second) as well as historical. Unfortunately, those two data sets alone do not tell where the market is heading next. This is why speculation and major events and news can drastically affect a securities list price, potentially wiping swaths of value from the company seemingly overnight.
The futures market is investors way to attempt to mitigate speculation by having investors invest in a future price by signing a contract to purchase at that price. Similarly, the options traders aim to invest indirectly by purchasing contracts tied to a securities price and attempting to get a discount or make money from a rise or fall in price (In options terms, buying a call or a put). As of writing, passive investing is largely in the purchase of individual stocks and ETF’s, not on the futures market and options contract book.
A Case for Savings Accounts
For many, the uncertainty of the stock market, and the knowledge and time required to maintain a portfolio is too much. Additionally, the lack of control and the possibility of a downturn may scare a potential investor away from passive investing. Luckily, banks have the solution. Through the use of savings accounts, banks give interest per month in a liquid (meaning you can access quickly) account. The interest rate is consistent and does not change often, which means you can calculate the expected return before the month begins. In addition, savings accounts never go negative on earnings, meaning a downturn may lessen your gains but never result in a loss.
That is unless you count inflation. At the current inflation rate of 2.2 percent (according to the Bureau of Labor Statistics), unless a savings account gives you a return of over 2.2 percent you are theoretically losing money to inflation (called purchasing power in business). According to industry analyst Nerdwallet (2018), the highest interest rate for savings account in the United States at the time of writing is 2.2 percent, with a national average of 0.09 percent. For example, simple, basic savings accounts from Ally Bank provides a 2.2 percent APY (annual percentage yield)(Ally Bank, 2019). After inflation, a customer is matching inflation each year, never really growing their purchasing power. However, those who use checking accounts to house funds gain minuscule interest (often 0.01 percent) which results in a larger loss to inflation in a given year.
As seen in Figure 2, the average person in the United States saves about $2,967.33 a year, meaning at the national average interest rate of 0.09% for savings accounts, an average of $2.67 is earned a year, whereas the equivalent of $65.28 of that initial deposit is lost to inflation, which is a $62.61 loss a year in purchasing power for using a savings account. This is not to discount the usefulness of savings accounts, as they do provide 900% more interest on average than checking accounts. In reality, savings accounts provide a place to store short term capital as well as accounts such an emergency fund or traveling/education funds that cannot be subject to the uncertainty that is the stock market.
Investing, either active or passive, is likely to beat the interest rate of a savings account and inflation to result in a net profit year over year. As with anything in economics, the more uncertainty you take on, the larger the cost or profit will be. This is precisely the crowd automated advisors and the Modern Portfolio Method aim to serve, those who know they should be investing but lack the time and knowledge to actively manage their own portfolio. It is also important to note however that investment accounts and savings accounts are taxed differently, as well as provide different access to capital. An investing account must settle (meaning sit with cash) for a time to comply with anti-money laundering laws. In addition, shares cannot be sold on weekends, holidays, or outside trading hours. Savings accounts, on the other hand, can be transferred to a checking account and used almost immediately with today’s technology and computerized banking. There are some restrictions (such as the number of transfers allowed each month) but for the most part, an average person will not run into an issue liquifying their savings.
Now What?
When deciding what to do with excess capital, it is important to remember recommendations will vary based on a variety of factors, including upcoming expenses, savings, and an emergency fund. In general, most financial planners will recommend getting essentials taken care of immediately, followed by insurance and an emergency fund (the size of which varies per person but hovers around 3 months of expenses or $1,000, whichever is more). Anything after that is excess capital. Here is where priorities, plans, and history come into play. Retirement, College Savings, and debt repayment are all considered at this stage, among other non-essential purchases. After all, this is accounted for is when financial planners will begin to suggest investing and/or maxing retirement.
As explained, the Modern Portfolio Theory enables those who would not be typically investing to start investing, often with small sums. While noble, many skip from essentials to investing, especially at a young age. This is dangerous since important steps such as emergency funds and retirement are not realized until it is too late. In the long term, having such safety nets will save in interest charges and tax bills in the future. But any strategy can be marketed this way, right? Right, with one exception being the Modern Portfolio Theory giving a false impression of being the ideal way to invest, with seemingly only upside. Utilizing technology also means it is easier to trip virtual ceilings and floors on the market, distinguishing from a routine correction or possible bear market.
In general, if you have managed money well enough to get to the investing phase, active investing will be the logical choice. Personally, a modified buy-and-hold is ideal, deciding a few securities in a diverse array of sectors to investing in each year after careful research. This differs from the Modern Portfolio Theory since as you can see in figure 1.1 & 1.2 asset allocations are split across the entire market. This is disadvantageous since if a particular sector is expected to be an outlier, it is in the best interest to act. For instance, if technology is looking promising in the coming year, but commodities are looking bleak, it would be advantageous to diversify within tech more than commodities. Even with automatic rebalancing offered by some robo advisors, it is a reactionary system utilizing the entire market without specific research. This process does reduce uncertainty but also reduced gains (or loss). It can be assumed that a well-informed investor will make a profit each year, sans an unexpected event (which can be addressed on a case-by-case basis outside of the Modern Portfolio Theory).
As always, an individual’s investment strategy varies and should be decided based on the goals and ability of the individual after careful consideration and consultation. The suggestions presented are not meant to be an individualized suggestion and reflect the views of the author.
Conclusion
Investing is often something many Americans are told they should be doing, especially at a young age where the money has time to incur the most gains. As the saying goes “it’s not timing the market, but time in the market” meaning it doesn’t matter when you start investing, as long as you start. This leads to a large market that currently trusts technology and suave marketing tactics and is convinced an automated advisor with a Nobel prize winning theory behind it will make them money overnight. Unfortunately, this is far from the truth.
The Modern Portfolio Method was is neither modern (at the fast pace of business and finance, 1950’s theories are often updated) nor a method (though it is used as such, it is a theory in practice). The name and associated Nobel Prize give it clout that it ought not to get. Education failures and personal finance training aside, it is simply not logical for a large swath of the robo advisors target demographic to be investing at all, especially in an ultra-conservative way in which the Modern Portfolio Method acts on.
Of course, all investing takes uncertainty, as well as an acceptance of the possibility of a loss, even in the long term. Automation, specifically using the Modern Portfolio Method’s formulas, aims to reduce this by hyper-diversifying funds across the market. While this is a way to mitigate uncertainty, it is not ideal for those who robo advising is marketed to in the short or long term. Savings accounts provide some form of safe haven, especially if chosen carefully. However, these funds are often growing at a slower pace and below inflation, essentially losing purchasing power while keeping money liquid and at a higher rate than checking accounts. After immediate purchases, emergency fund, and savings it is important to focus on other tax-advantaged routes such as retirement and college savings plans. Then, it is recommended to start investing. It is easy to see how the target demographic does not have the capital to succeed in such a scenario.
Instead, young investors and those currently appealed to by passive investing should combine their merits and research different sectors and securities and diversify accordingly, solidifying their choice for the long term (at least 1–2 years). This enables the investor to directly contribute to the companies and commodities that they have a strong backing will do well to accomplish their specific goals. While this is not entirely automated and not as conservative, the potential for benefit is often greater the earlier in life investment is started. Assuming proper personal finance in other areas, a deep dive into financials and a basic education about the economy and the market will ultimately yield better, more decisive actions.
