Wade Pfau, Ph.D., CFA

Modern Portfolio Theory – Part Two

This article is part of a series; click here to read Part One.

Efficient frontier diagrams do not actually show the asset allocations of portfolios on the efficient frontier, but this information is also available. Exhibit 1.3 provides an example of ten portfolios on the efficient frontier shown in Exhibit 1.2. These range from the lowest return and volatility combinations to the highest return and volatility combinations. For example, portfolio one is listed with a 3.8 percent return and 3 percent volatility. This portfolio consists of a 91.3 percent allocation to Treasury bills along with small allocations to corporate bonds (7 percent), small-cap stocks (1.3 percent), and large-cap stocks (0.4 percent). Despite small-cap stocks being the most volatile asset class choice, the low correlation of characteristics it shares with other asset classes helps it to play a small role in a low volatility portfolio. The overall portfolio volatility of 3 percent is slightly less than the 3.1 percent volatility of Treasury bills on their own. Then, as we move down the list, we find portfolios with increasing returns and volatilities that contain increasing allocations to stocks and a gradual phase out for Treasury bills and other bonds. The fifth portfolio is the most diversified with an allocation to five of the six asset classes. It provides overall returns of 9.3 percent with a volatility of 11.2 percent.

Exhibit 1.3 A Selection of Outcomes from the Efficient Frontier as Based on US Financial Market Nominal Annual Returns, 1926–2018

Source: Own calculations from SBBI Yearbook data provided by Morningstar and Ibbotson Associates.

We now understand that there are serious issues with using MPT to determine investment portfolios for household investors, especially after retirement begins. Harry Markowitz recognized this. After winning the Nobel Prize in 1990, he was asked to write an article in 1991 for the first issue of Financial Services Review about how MPT applies to household investors. This article was named, “Individual versus Institutional Investing.” In the article, he writes about how he had never thought about the household’s investing problem before, and after reflecting on it for an evening, he realized that households face a very different investing problem from the large institutional investors, such as mutual funds, he had in mind when developing MPT. MPT does not teach how individual households should build investment strategies to meet their lifetime financial planning goals.

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Namely, and this is really the key for understanding how the retirement income problem differs from the MPT approach, households must meet spending goals over an unknown length of time in retirement. MPT just seeks how to grow wealth over a single time period, such as a year, when there is no need to take distributions from the portfolio. It is an assets-only model. The preretirement wealth accumulation notion that households seek to grow wealth is more closely aligned with MPT, but the retirement income problem is vastly different. There may surely be a relationship between the idea that having more wealth will support more spending, and the idea that building diversified portfolios is still valid, but that relationship is more complicated when it is unknown how long the spending must last and when taking distributions from assets works to amplify the impacts of investment volatility on the retirement income plan.

With sequence risk for portfolio distributions, the extra shares sold to meet a spending goal when markets are down are no longer available to experience the growth of any subsequent market recovery. The point chosen on the efficient frontier can be different when viewed in the context of the household’s problem, and there can be a role for annuities or other risk management tools that are not included as asset classes in traditional MPT. Simply, MPT does not account for cash flows or longevity risk. It equates risk with short-term asset volatility rather than with the ability to meet financial goals.

Risk in the context of the household’s investing problem is only tangentially related to the volatility or standard deviation of returns. Volatility is important in that it relates to risk tolerance and whether individuals can handle the short-term volatility of their portfolio. If greater volatility leads them to not stick with their financial plan, then this must be incorporated into the asset allocation decision. But more generally, risk for the household relates to the ability to meet financial goals over a long-term planning horizon.

A low-volatility portfolio offering insufficient return potential can ensure failure for the financial plan. This is riskier from the household’s perspective than a more volatile portfolio that supports a higher probability of success for the financial plan. A key difference between probability-based and safety-first approaches is that the probability-based approach is more comfortable with accepting greater volatility for higher return potential and an improved chance for success, while the safety-first approach looks for alternatives that do not expose core retirement spending goals to market volatility. The question is ultimately about which is the best way to be able to spend more than a bond ladder can support: to rely on the excess returns expected to be provided by the stock market, or to rely on the power of risk pooling to bring additional spending power to those facing a higher cost retirement.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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