Modern portfolio theory

Modern portfolio theory (MPT)—or portfolio theory—was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection.

Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing a mathematics of diversification, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities.

If we treat single-period returns for various securities as random variables, we can assign them expected values, standard deviations and correlations. Based on these, we can calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxy's for risk and reward. Out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier.

James Tobin (1958) expanded on Markowitz's work by adding a risk-free asset to the analysis. This made it possible to leverage or deleverage portfolios on the efficient frontier. This lead to the notions of a super-efficient portfolio and the capital market line. Through leverage, portfolios on the capital market line are able to outperform portfolio on the efficient frontier.

Sharpe (1964) formalized the capital asset pricing model (CAPM). This makes strong assumptions that lead to interesting conclusions. Not only does the market portfolio sit on the efficient frontier, but it is actually Tobin's super-efficient portfolio. According to CAPM, all investors should hold the market portfolio, leveraged or de-leveraged with positions in the risk-free asset. CAPM also introduced beta and relates an asset's expected return to its beta.
Portfolio theory provides a broad context for understanding the interactions of systematic risk and reward. It has profoundly shaped how institutional portfolios are managed, and motivated the use of passive investment management techniques. The mathematics of portfolio theory is used extensively in financial risk management and was a theoretical precursor for today's value-at-risk measures.

Investment Policy Statement (IPS) Basics

This is a sample of what the IPS says in its first page. It's the investment advisor explaining what an IPS is to the client.

The Investment Policy Statement is the linkage between you, the investment manager, and your portfolio.

The most important duty of a fiduciary or trustee is the creation and maintenance of an Investment Policy Statement. This is an important written document that should clearly define your objectives and constraints over a relevant, explicitly stated, time horizon. The IPS is the foundation of managing your investments, and serves as a structured decision-making process for us to make most all of your investment decisions. This helps to balance return seeking and risk taking; increasing the probability of success in achieving your long-term investment goals.
A properly constructed Investment Policy Statement provides support for the investment manager to follow a well-conceived, long-term investment discipline, rather than one that is based on ad hoc revisions spawned by overconfidence or panic in reaction to short-term market fluctuations. The absence of written policy reduces decision making to an individual event basis and often leads to chasing short-term opportunities that may detract from reaching long-term goals. The presence of policy encourages all parties to maintain their focus on the long-term nature of the investment process, especially during turbulent, or exuberant, times.

The IPS provides a long-term plan and a basis for making disciplined investment decisions over time. Written investment policy helps to clearly and concisely identify your pertinent objectives and constraints. Once this is done, we can establish investment guidelines that we feel are appropriate, given the universe of strategies and realities of the marketplace.

Clients are surprised when they realize they are responsible for establishing their own investment policy. Once established, it is then the advisor's role to follow that policy. Once policy is established, we would not expect to change it until there is a material change in your personal or financial circumstances. Investment policy normally doesn't change in response to market moves, and should be long-term to prevent arbitrary or impulsive revisions.

The Investment Policy Statement also provides an effective channel of communication between client and advisor. This will help clarify issues of importance and concerns to both parties. Conflicts of interest and general misunderstandings are minimized since the IPS is in writing and both the client and investment managers have agreed to adhere to it.

Having a professionally prepared IPS also helps provide a structured means of presenting investment performance, and provides continuity from current manager(s) to future ones.
Rate of return objectives are mostly tempered by your risk tolerance, but other factors also apply. These are constraints, such as: time horizons, income/liquidity needs, tax considerations, legal and regulatory requirements, and unique preferences or circumstances. These objectives and constraints, considered in the light of investment market expectations (expected returns, return volatilities, and return correlations), will dictate the appropriate investment strategies to be followed, including asset allocation and selection, the investment style to be pursued, and the appropriate way to monitor and evaluate performance.

Signing and returning the IPS will let us know that you concur with its contents. This Investment Policy Statement is not a contract of any kind, and it is not required to make trades in your account. It is only meant to be a summary of our agreed upon investment management techniques. You can suggest any changes you want to it before formally agreeing to it with your signature.

More IPS Basics

An Investment Policy Statement has five components:
1) Account information and summary of investor circumstances.
2) Investment objectives, time horizon, and risk attitudes.
3) Permissible asset classes, constraints, and restrictions.
4) Asset allocation ranges and targets.
5) Selection, monitoring, reporting, and control procedures.

To serve as the guide in making investment decisions, your Investment Policy Statement will summarize:

º Your financial goals and objectives; and time frames for reaching them.
º Your personal preferences and constraints, and any tax, legal, or regulatory issues.
º Your rate of return goals.
º Your willingness and ability to assume investment risk (summarized by your investment risk tolerance category).
º Your ongoing income distribution needs from the investment portfolio, and other liquidity concerns stemming from withdrawals from the portfolio.
º Personalized guidelines for the allocation of your assets. This process will determine which overall asset classes will be used, and how your assets should be divided between these asset classes. Your personal (non-tax qualified) assets may be allocated separately from your qualified retirement assets, or they may be combined.
º The time frame for achieving your proposed asset allocation, and when rebalancing is required.
º Whether techniques such as Dollar Cost Averaging will be used in achieving allocation ranges over time (for equity classes only).
º Whether or not portfolio optimization techniques will be used to enhance investment performance by helping to control risk and return.
º Benchmarks to be used in evaluating investment performance, and how they will be applied.
º The frequency and types of portfolio reporting and evaluation.
º Security selection guidelines used to control how much of a certain type, and which types, of investments are permissible.

The Benefits of Using an IPS:

Using a properly composed Investment Policy Statement should bring the following benefits:
º An IPS compels the investor and the investor's advisors to be more disciplined and systematic in their decision making, which is in itself, should improve the odds of meeting the investment goals.
º Objectives and expectations are clarified for all concerned parties.
º Misunderstandings are more likely to be avoided.
º Approved procedures are specified so everyone concerned will know what to expect. Decisions can be made as to how things will be done under a variety of circumstances in a deliberate fashion, rather than in the "heat of the battle." Planning ahead makes it easier for all when the environment gets stormy.
º The IPS established a record of decisions and an objective means to test whether those serving the investor are complying with the investor's requirements.
º The Investment Policy Statement provides a ready means to communicate to advisors, beneficiaries, and current and future fiduciaries about how the investor proposes to go about acting upon their duties.

Who Needs an IPS

Every investor needs an Investment Policy Statement. In certain circumstances, law mandates having it in writing. When it is mandated by law? In general, having an Investment Policy Statement is required any time a person or group of people are making investment decisions for the benefit of others, whether or not the decision-makers also may have a direct personal interest in the assets. For example: When the investments are subject to ERISA, Taft-Hartley Plans, held in a trust/endowment/foundation, when the assets are in an estate and the executor is making investment decisions, or when there is more than one investment manager acting in a fiduciary capacity under the Uniform Prudent Investor Act.

Book Review: All About Asset Allocation. By Richard A. Ferri, McGraw-Hill

The elimination of many defined-benefit pension plans and the possibility that the U.S. Social Security system may be overhauled have placed much of the burden and responsibility of retirement planning on the individual. These changes, together with increasing life expectancies, are making the investment allocation decision much more critical than in the past. But where should an individual investor go to gain the insights to construct an appropriate portfolio?

Numerous books will provide basic investment strategy and financial planning. Many of these books do a good job of giving investors an overview of the available investment alternatives, but few provide a clear and intuitive explanation of the asset allocation decision. In the widely regarded Bogle on Mutual Funds: New Perspectives for the Intelligent Investor (Dell, 1994), John Bogle does an excellent job of taking the reader through the process of selecting common stock, bond, and money market mutual funds. Of the 300-plus pages devoted to mutual fund investing, however, only 22 pages address asset allocation. Similarly, David Swensen's Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005) takes a thorough look at the mutual fund industry, but although Swensen devotes an entire section of the book to asset allocation, he focuses on which assets to hold as part of a core portfolio. He provides little discussion of how to construct an appropriate asset allocation or the benefits of doing so. Other books, such as Jeremy Siegel's classic Stocks for the Long Run (McGraw-Hill, 2002), use historical data to strengthen the argument for holding equities but offer no insight into the portfolio decision.

Those of us who have studied or taught courses in investments and portfolio management know that the textbook coverage of asset allocation is often restricted to a mathematical exposition of modern portfolio theory. These mathematical models, although elegant, tend to obscure the intuition behind the asset allocation decision for many students. In All About Asset Allocation, Richard A. Ferri, CFA, president and senior portfolio manager of Portfolio Solutions, LLC, attempts to bridge the gap between math and intuition by providing a readable discussion of this critical and often neglected aspect of investing. In many ways, Ferri is attempting to do for asset allocation what Peter Kennedy did for econometrics more than two decades ago in A Guide to Econometrics (MIT Press, 1985; first published by Martin Robertson and Company in 1979). Kennedy strove to strip away the mathematics of econometrics in order to provide a clear, intuitive understanding of this mathematically rigorous subject.

Although All About Asset Allocation is targeted to the less sophisticated investor, it should be valuable also to market professionals who counsel individual clients. The book contains many of the same graphs that can be found in standard texts, but because Ferri omits the mathematics that generate these graphs, the reader tends to focus on the concepts underlying the asset allocation decision. The intuition for asset allocation is further supported by numerous tables and charts of historical returns for various asset classes, in a fashion reminiscent of Siegel. Ferri also provides one of the more accessible discussions of the risk premium by stacking various types of risk premiums on the U.S. T-bill rate. In addition, Ferri presents a good review of behavioral issues in finance, issues that may be of value when communicating with clients.
Ideally, everyone with money to invest should be aware of the issues discussed in this book. Unfortunately, a book about asset allocation is unlikely to supplant investment books written by two brothers wearing court jester hats like the Motley Fools or a Suze Orman trumpeting the courage to be rich. The burden consequently falls on those who either work in the field of financial planning or are involved in training the next generation of financial professionals. They will find All About Asset Allocation an excellent tool for communicating to clients the importance of holding a well-diversified portfolio.
—R.L.M.