Has goal-based investing ruined Modern Portfolio Theory?

by Hansi Mehrotra

18th November 2016

Modern or mean-variance portfolio theory (MPT) is an important financial concept. But it has little practical value for retail investors when it to comes to asset allocation.

Recently, goals-based investing has grown popular with both financial advisers and robo-advice tools. Financial advisers continue to apply an ‘”asset allocation overlay” check to ensure goals-based portfolios are not too risky when viewed through the MPT lens.

It’s time to develop a more practical risk-management measure.

It has taken me 20 years of wealth management industry to say this: while MPT is an elegant theory, it fails when used for retail investor client portfolios.

Let me explain why.

The Exclusion of Illiquid Assets 

My clients were real people who liked real assets, especially a roof over their heads. So when I offered to rescue their haphazard collection of bank deposits, stocks, bonds, funds, and real estate by devising an “optimal” asset allocation, I would always be stumped as to whether to include their primary residence.

Since real property is a fairly common method to build wealth in a tax efficient way, I didn’t see the logic of excluding it. On the other hand, including it would swamp the asset allocation with “idiosyncratic residential property risk.”

I had no choice. I had to ignore pretty much all real estate due to its lumpy nature.

Often clients also had large amounts in bank-fixed deposits that they weren’t keen on investing in capital markets just because my efficient frontier calculation recommended it. Nor were they willing to sell any large direct-share holdings acquired as part of an inheritance or employee stock option plan. As a result, I would devise an optimal portfolio of mutual funds available on whatever platform I happened to use.

How much more efficient would the portfolio have been if I had access to private equity and hedge funds, or indeed, to those assets available to investors in other parts of the world? Does the difficulty of accessing an asset class render a portfolio made up of only immediately available asset classes inefficient?

The practical constraints of having to exclude certain real property assets, or not being able to include other assets currently unavailable, seemed to compromise the point of the exercise.

Difficulties in Forecasting, Risk Profiling, and Definitions

Often savvy clients sought advice from multiple advisers. They would question why the recommendations for the right or optimal asset allocation varied. Rightly so.

To the clients, it appeared as though the various advisers used different assumptions for long-term expected returns without necessarily having a reasonable basis for their views. Without a doubt, all advisers struggle with forecasting volatility and correlations. Most advisers use historical data as the basis for their opinions, but data histories vary. As clients focused on the discrepancies, financial advisers realized the difficulty of long-range forecasting.

The bigger issue, however, is the risk-profiling process. There aren’t any definitions of risk profiling, let alone any industry standards on how to conduct it. Firms regularly use a set of arbitrary questions to arrive at even more arbitrary risk profiles.

After some regulatory intervention, it became possible to compare risk profiles based on expected return and risk outcomes. Unfortunately, the return and risk assumptions varied, so the risk profiles weren’t strictly comparable — they still aren’t. And there are still no regulatory standards on risk profiling.

I left my financial adviser role to become a research analyst. I yearned for intellectual rigor. The more I researched, the more I realized that the MPT issue starts with the very definition of an asset class.

What constitutes an asset class? How different does the risk/return have to be for a subset of an asset class to be carved out into a separate asset class? For example, why do domestic equities qualify as a separate asset class to global equities? Should emerging markets and high-yield debt be carved out of global equities and fixed income, respectively?

The Rise of Behavioral Finance and Goals-Based Investing

I was delighted to discover behavioral finance in the late 1990s. Finally, here was evidence MPT wasn’t wrong, clients were just irrational. Their mental shortcuts — their  anchoring, hindsight bias, and overconfidence — explained why client portfolios and returns were suboptimal.

Inspired, I started to educate investors about their mistakes in the hope they would realize their follies. That is, until I realized I had organized my own finances in three mental buckets just like the irrational investors in the behavioral finance textbooks. I had a lot of cash in my short-term bucket, real estate in my medium-term goals, and all of my superannuation into equities as a long-term prospect.

I was behaving pretty much like my clients.

Gradually, the investment industry evolved from correcting investor behavior to designing client-centered products and services. It started with “nudges” like better designed default options, auto-enrollment, and automatically saving future salary increases. Next we saw the advent of goals-based investing, creating separate portfolios for each client goal: buying a house, an education, or funding retirement.

But financial advisers (and their robotic counterparts) continue to calculate the weighted-average asset allocation of the various goals-based portfolios and force fit it into the assessed risk profile — which is still determined by arbitrary questions. Even Ashvin B. Chhabra’s brilliant paper on goals-based investing, “Beyond Markowitz,” advocates the MPT-based asset allocation overlay.

Denouncing Nobel-Prize winning MPT is heresy. Or is it? Wasn’t reducing risk its purpose? Aren’t there better ways to do that?

As a financial educator, I hope to influence the millions of people in middle-class India, and I am concerned about scale. If we can’t reach all investors through financial advisers, how can we teach them to fish — or invest — themselves? If I did just fine building my own portfolio with a few mental buckets, why can’t we teach investors to do the same?

I finally had the courage to admit what I had struggled with throughout my career: MPT was never practical enough for retail investors. The time has come for the wealth management industry to admit it as well .


This post was written by Hansi Mehrotra and originally appeared on the CFA Institute site. (https://blogs.cfainstitute.org/investor/2016/11/18/has-goals-based-investing-ruined-modern-portfolio-theory-mpt/)

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