Vestelligent - White Paper

7/30/2019 Vestelligent - White Paper

1/4

Why Investment Advisors Will Continue To Steer You The Wrong Way

The first decade of the 21st century has been a trying one for investors, but what if the travails of the2000s are partly a result of 20th century theories that professional investment managers didnt leave

behind? Modern Portfolio Theory (MPT) sought to create a comprehensive model for analyzing the

behavior and risk of assets. These models of risk may have seemed good in the lab, but mounting

empirical evidence has continued to call into question their premises. While probability models and

statistics have their uses, MPTs reliance on historical data leaves market participants consistently

awestruck when assets dont perform according to the model. Instead of finding a model that fits the

observational data, the data is forced to fit the existing theory, perhaps with minor alterations as new

events dictate. This is not merely an academic discussion as the precepts of these theorems are thefoundation for portfolio construction and in all likelihood shape the decisions of your investment

advisor. These decisions have had adverse consequences on investor confidence and more importantly,

investor success.

The foundation of asset management is Modern Portfolio Theory. MPT asserts that investors should

seek to maximize returns for a given level of risk. This is graphically displayed as the efficient frontier

(see figure 1).

Figure 1*


2/4

Portfolios along this frontier are thought to be the most efficient balance of portfolio risk and reward.

Risk is defined as the volatility, or standard deviation, from the historical average return of an asset. This

return maximization is achieved through diversification among holdings (with different profiles of risk

and return) that create a lower overall portfolio risk. For example, if your stock positions are going

down, this will be offset by bond positions going up, thus lowering the overall volatility of your portfolio.

In creating a portfolio, MPT utilizes both historical performance data and the concept of a normal

distribution of returns. A normal distribution is graphically represented as the standard bell curve (see

figure 2).

Figure 2**

The frequency of events is measured by the vertical axis, and the severity of the event is measured by

the horizontal axis. For portfolio or investment returns, the curve is graphically displaying how often

different returns occur and how much they vary from the average. Thus, mild events, or returns close to

the average, happen quite frequently as seen in the center of the bell curve (dark blue), and high

severity events or returns very different from the average, at either end of the curve happen so rarely as

to be nearly impossible statistically. High severity events such as the bursting of the tech bubble, the

bursting of the housing bubble, the ensuing market collapse, and the European sovereign debt crisis are

100 year flood type events. Thus, the frequency with which these events have continued to occur calls

into question whether or not returns are in fact normally distributed. The 2007-2008 crisis wreaked such

havoc due to its lack of precedence. This is due to MPTs reliance on historical data and a misplaced faith

that events of this magnitude rarely if ever occur. Assets that historically werent supposed to decline in

tandem did and on a scale never before seen. If the model that is the underpinning of investment

managersdecision making processes doesntaccount for these market anomalies, is it any wonder

that we hear the echoes of experts claiming, no one could haveseen this coming?

If youre not looking for the problem, it is easy to miss it.

In addition to a reliance on historical data and a faulty belief in normally distributed risk, the next

shortcoming of MPT is its view that financial markets are efficient and participants act in a rational

manner to achieve the above mentioned return maximization. This is known as the Efficient Market

Hypothesis (EMH). Market efficiency, as defined by EMH, is an instantaneous synthesis of relevant price

data. While EMH argues that historical price performance does provide information as to the statistical


3/4

probability of returns and deviation from those returns (volatility), price movements are random and

exhibit no discernible pattern. With the start of a new century that has been marked by a tech bubble, a

housing bubble, and a sovereign debt bubble, the problematic nature of the Efficient Market Hypothesis

should be clear.

Investors are not rational, at least in the manner defined by MPT and EMH and, in

fact, are far more risk adverse.

The fear of loss is a far greater motivator than the potential for gain. This manifests itself in participants

selling at market bottoms (fear of even greater losses) and buying late into market recoveries as they

wait for an all clear sign. This is not the rational behavior of market actors seeking the risk adjusted

return maximization that MPT and EMH suggest exists. As the example crises above illustrate, markets

do not efficiently process data as it moves from one price point to another. Trends do emerge as

manifested in bubbles and busts. Markets, like the constituent investors who comprise them, seem to

exhibit a memory of past price movements that can influence future price movements.

Modern Portfolio Theory gave rise to the ubiquitous asset allocation or risk based investment models.

For those having worked with an advisor, you are familiar with the risk tolerance questionnaire that

every advisor will have you fill out. It is a series of questions meant to determine the investors risk

profile: conservative, moderate, aggressive, etc. From this, the appropriate allocation to stocks and

bonds can be created to maximize returns given the level of risk the investor is willing to take (based on

the efficient frontier above). From the analysis of MPT, we can see a number of errors in this strategy.

As discussed above, investors are far more risk adverse and do not necessarily look to maximize returnsbut rather avoid loses. Second, investors responses can be anchored to recent experience. For example,

a hypothetical client in late 2007 may have been much more willing to take on risk with equity markets

hitting new all-time highs. However, that same client answering the same risk tolerance questionnaire in

March 2009 at the market lows may have responded in a much more risk adverse fashion. Our construct

of risk is shaped by the current market environment. With the damage caused by the 2007-2008 crisis

still ingrained in investors minds, they rush for the exits at the hint of another downturn. This has been

exacerbated by the trendless and volatile environment of the past two years. Markets have been held

captive by the utterings of every central banker and policy maker. The net result of portfolios built on

poor projections of risk is that clients are being pushed into portfolios that continue to experience

higher volatility than they can truly stomach. As a result of each unexpected crisis, advisors are notable to properly manage client expectations, and oftentimes, investors will be shaken out of their

positions at the worst possible time.


4/4

Confined within itself, the conclusions and formulas of Modern Portfolio Theory

may be valid. However, if it does not model actual human behavior, the theory

must be discarded.

The consequences are not merely academic and shoulder a great deal of the blame for the loss of

investor capital and confidence. As governments and central banks attempt to work off unsustainable

debt levels, the ideal scenario for policy makers would be a continuation of the past few years: low

growth and high volatility or a policy of muddling through. Policy makers want to avoid losing control of

the situation in one direction or the other. However, this is requiring greater and greater intervention

just to maintain the lackluster status quo. Assuming that they can continue to arrest natural market

forces, volatility is here to stay and in all likelihood, may only increase. Our assessment of risk and

portfolio construction must adapt accordingly.

Next Steps To Help You

We hope that our brief overview of the theory that investment advisors across the world rely on was

informative. The financial planning and wealth management industry is ripe for disruption. It's time

investors stopped paying rich fees for poor advice. Our platform will solve the pervasive problems

plaguing the industry that advisors are ill-equipped and unwilling to face. With the scale and

transparency that the internet provides, we will deliver the services that you, the end user, have been

looking for. Thank you for your early interest in our journey.

If you have a few extra minutes, wed love for you to take this 10 question survey. You will have theability to be a first adopter of our system with your feedback. We would truly appreciate your help.

Take the survey now!

*IBM, http://www.ibm.com/developerworks/rational/library/aug05/mckenna/mckenna_fig1.jpg

**Wikipedia, http://upload.wikimedia.org/wikipedia/commons/thumb/8/8c/Standard_deviation_diagram.svg/325px-

Standard_deviation_diagram.svg.png
http://www.surveymonkey.com/s/BVTXBPDhttp://www.surveymonkey.com/s/BVTXBPDhttp://www.surveymonkey.com/s/BVTXBPD

Documents

Vestelligent - White Paper