Some of you may have heard about “Modern Portfolio Theory” (MPT). Maybe you heard it in your economics class, on TV, or from a financial professional. It’s one of those theories that sounds familiar but it’s very easy to forget. Let’s face it, the financial industry is not the most exciting topic to learn about. Among investment portfolio managers, MPT is one of the most commonly practiced investment principles to this day. The name sounds new and trendy but how modern is Modern Portfolio Theory?
The strategy isn’t as modern as you may think. MPT was developed by Harry Markowitz in a paper titled “Portfolio Selection” in 1952. That’s right. Most of what you know about structuring your investment portfolio was known before microwaves, Velcro, and color TV! MPT is a theory that believes an investor can manage the overall market risk of an investment portfolio in order to obtain a more consistent and less volatile rate of return. MPT also provides investors with what is called the Efficient Frontier. This is a guide informing investors about different asset classes and the risk associated with each allocation decision made. For example, you can allocate your money into cash, stocks, or bonds but not all risk is equal with each decision. The Efficient Frontier is a tool meant to guide investors on exposing their portfolio to the right amount of risk to achieve the right amount of reward. For decades, MPT was imprinted in investor’s minds when it came to the construction and management of a properly allocated portfolio.
Decades later, in 2005, a man by the name of Ashvin Chhabra wrote a paper called “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors.” Mr. Chhabra was inspired to write a paper that challenged Modern Portfolio Theory when he realized that MPT did not address the goals or desired lifestyles of investors. Chhabra also recognized the importance of real assets such as real estate or a profitable business. Real assets are well known among investors and for most, it’s what creates their wealth. These missing assets when constructing an investment portfolio can drastically affect the amount of wealth an investor is able to accumulate over time. Mr. Chhabra points out that not all levels of wealth creation is desirable to all investors and defines Aspirational Risk as the amount of risk investors take to build wealth measurable and relative to their peers. He also mentions the importance in measuring one’s Personal Risk, which is the level of risk an investor is able to tolerate based on their current financial health, financial timeline, and ability to take risks that potentially result in excessive losses. Personal risk is circumstantial to each investor and determines the level of wealth needed to make an investor feel safe. Chhabra went “beyond” the basic allocation laws of Markowitz and set new rules for investors to ensure that not only is their investment portfolio properly allocated, but their entire wealth should be allocated based on the goals, levels of safety, and risk behavior associated with each investor.
If we wanted to organize our wealth allocation and visually see it, some experts have illustrated the theory as three risk buckets. Each bucket symbolizes a level of risk and it is wise for an investor to not continue to the next bucket without ensuring that the previous bucket is full and secure. Bucket one is personal safety and to make sure needs are met. Bucket two is the ability to diversify wealth while creating the potential opportunity for financial gains that protect investors from inflation while maintaining their lifestyle conservatively over an extended period of time. Finally, bucket three is the ability to potentially enhance one’s lifestyle significantly by exposing themselves to highly concentrated and high-risk investment opportunities. Being that there are only so many ways to accumulate such massive amounts of wealth, it’s important to understand that a very small percentage of people ever make it to bucket three. So, I challenge you to sit down one day and draw your own buckets and write down each asset you own in its appropriate place. Once you’re done, analyze your situation. Is your first bucket secure? Did you move on too early? Is bucket 1 and 2 full and fear of failure is holding you back from bucket three?