Modern Portfolio Theory revisited

Yesterday morning I attended the St. Louis Chapter of the Financial Planning Association meeting to hear a presentation titled “Modern Portfolio Theory 2.0.”  It was excellent, no surprise, because it was presented by Michael Kitces  MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL whom I often describe as a “walking brain” when discussing him with peers.  He is also the author of a reference book I own, and to which I often refer.

Michael came in from the Washington DC area to share his research on market and economic history, the accompanying signals and data, and what it has told us about subsequent market performance.  He also had ideas for how this information could be layered on top of Modern Portfolio Theory in a tactical way to mitigate some risk in client portfolios.

Modern Portfolio Theory

In the 1950’s, Dr. Harry Markowitz pioneered the idea of considering your investment portfolio as a whole unit, rather than as individual securities, when measuring risk and expected return.   He determined mathematically, that you could put investments in the portfolio that had a bit more risk (more volatility) and yet create less volatility in the portfolio as a whole.

This reduction in volatility was accomplished by having investments that were not completely correlated, meaning they did not move in tandem.  So when one investment zigs another one zags.  In effect, when you have multiple investments moving in different amounts of up and down directions at different times, it creates a smoother path overall.

There are different steps involved in implementing Modern Portfolio Theory.  I gave a “plain English” version of the Asset Allocation step in my blog post “Peter Cottontail Makes A Lousy Investment Advisor!” which explains the reasons for diversification and rebalancing a portfolio.

Modern Portfolio 2.0

In his presentation Michael pointed out three factors that make following Modern Portfolio Theory, without any adjustment, challenging.

  1. Returns – they seem to vary for an extended period of time
  2. Standard Deviation – there are distinct high and low volatility periods
  3. Correlations – became close to 1 during the recent crisis

He shared with us different valuation data points, macroeconomic information, and technical trend analysis information to evaluate when considering adjustments to Modern Portfolio Theory inputs.

I have seen Michael speak on similar topics and can see that his research is expanding, he shared more data points and ideas for implementation than in the past.  I look forward to seeing where the research leads.

Financial Planning Association: An Educational Benefit

What is the Financial Planning Association (FPA)
The Financial Planning Association is the largest membership organization dedicated to supporting personal financial planning experts in the nation. While it is generally thought of as the group for CFP® practitioners, you do not have to be a CERTIFIED FINANCIAL PLANNER™ to belong. People who support the financial planning process are able to join as well. There are about 95 chapters nationwide and tens of thousands of members. There are about 15,000 members who are a CFP® practitioner. Other types of professionals that are members are attorneys, CPAs, insurance agents, investment company representatives, and others.

Stay up to date on financial planning topics

The St. Louis, MO chapter has a monthly meeting. Each month there is a different guest speaker, usually someone local, sometimes someone from out of town. This is a good way to stay up to date on various subjects. Past topics have included; a tax update with a focus on estate planning, a health insurance reform update, economic update, and Medicare information. Future topics this year include; the banking crisis, alternative investment strategies, long-term care protection planning, tax traps in annuity planning, and Modern Portfolio Theory 2.0. I earn continuing education credit hours for attending these educational meetings, which is fortunate because I need many hours as a requirement for my designations and memberships in some organizations.

Financial education resources

This is an industry that is full of constant change so reading is a must. As a member I receive a subscription to the Journal of Financial Planning, access to research and whitepapers, and a daily retirement planning newsletter e-mail. I also receive subscriptions to Kiplinger’s, Bloomberg Businessweek, Money, and Smart Money, so that I can stay on top of what my clients are reading.

There are different reasons that I am a member of each of the professional organization to which I belong; the National Association of Personal Financial Advisors (NAPFA), the Garrett Planning Network, and the Financial Planning Association (FPA). The primary reason I belong to the Financial Planning Association is for the educational benefit to me which of course benefits my clients in the long run.