The Evolution of Investing

If we went back 50 years in a time machine, no one would have the slightest clue what is an investment portfolio.

Amazingly, something as fundamental as asset allocation in a portfolio didn’t exist until the late 1960s. I want to explore with you the evolution of the modern portfolio from its humble beginnings. 

First, What is Investment Portfolio?

“An investment portfolio is a grouping of financial assets—such as stocks, bonds, commodities, currencies, alternatives, and funds—that an investor purchases to produce income and meet his family’s financial goals”.

The Evolution of the Modern Portfolio

In the early 18th century, Daniel Bernoulli proposed that individuals maximize expected utility when they make decisions under uncertainty. This reasoning launched the rationality model of human behavior that underpins many of today’s theories in economics and finance, including modern portfolio theory (MPT). The mathematical models that sprang from these theories provide a veneer of orderliness while obscuring the behavioral messiness of real-world financial markets.

In 1952 Harry Markovitz changed the investment world by publishing his article on portfolio selection, arguing that portfolios should optimize expected return relative to volatility, with volatility measured as the variance of risk and return. He proposed the now ubiquitous efficient frontier. By the mid-1960s, this mean-variance model had become a mainstay within academic finance departments.

The MPT Theory

Harry Markovitz’s research was given the Name “The Modern Portfolio Theory” or simply MPT. The modern portfolio theory is a practical method for selecting investments to maximize their overall returns within an acceptable level of risk.

A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return. Markovitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk.

The modern portfolio theory argues that any given investment’s risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio’s risk and return. Thus, an investor can construct a portfolio of multiple assets that will result in greater returns without a higher level of risk.

Based on statistical measures such as variance and correlation, a single investment’s performance is less important than how it impacts the entire portfolio.

How MPT Became the Ascendant Paradigm?

Combining Markowitz’s model with restrictive assumptions regarding investor rationality, information availability, and market trading structure, Bill Sharpe derived a model of capital market equilibrium in the mid-1960s. Soon the capital asset pricing model (CAPM) became a central tenet of MPT.

Eugene Fama erected the final pillar of the MPT theory in the mid-1960s, in perhaps the most famous finance doctoral dissertation of our generation. Extending the concept of rational investors to its logical conclusion, Fama proposed the efficient market hypothesis (EMH), that financial market prices reflect all relevant information and thus generating excess returns (Alpha) through active management is impossible. 

MPT quickly became the ascendant paradigm. For the quantitative-based analysts who dominated the investment industry, a simple theory like MPT that explained messy financial markets was very attractive. Now they had a rigorous theory of markets and a rational approach to building investment portfolios.

The First Shots Were Fired Across MPT’s Bow in the Late 1970s

The initial CAPM empirical tests uncovered a negative return to the beta relationship, the opposite of what was predicted. Rather than reject CAPM, however, the discipline responded by searching for statistical problems in these tests.

In the early 1980s, Nobel Prize winner Robert Shiller argued that almost all volatility observed in the stock market, even on an annual basis, was noise rather than the result of changes in fundamentals. Since EMH held that prices fully reflect all relevant information, volatility driven by anything other than fundamentals strikes at the very heart of the MPT theory.

Shiller’s Noisy Market model also created problems for Markowitz’s portfolio optimization. If volatility is the result of emotional crowds, then emotion has been placed in the middle of the portfolio construction process. So rather than being a risk-return optimization, it is an emotion-return optimization. In summary, all pillars supporting EMH and MPT had been toppled.

Next, Daniel Kahneman who is a professor emeritus of psychology and public affairs at Princeton University, despite never having reportedly taken a course in economics, emerged with the “behavioral economics theory”. In 2002, he was awarded the Nobel Prize for his research on prospect theory, which deals with human judgment and decision-making.

Now decades later, there is little evidence to support MPT. It seems it is time to move on. There is an alternative way to view securities markets, their movements, and their participants: behavioral finance and the transition to ALM. (Asset Liability Management)

The new theories that are emerging from academic research are simple “ The Key to bringing real value to clients in the investment world is understanding them and their life goals”

The “Yale Model” arrives 

Swensen of Yale University joined the league of elite academics of the investment world.

Few academics can rival the late David Swensen, former head of the Yale Endowment. As Chief Investment Officer of this multi-billion-dollar fund, he delivered top performance over multiple decades, and his investing style influenced an entire industry. Swensen’s innovative and rigorous approach to asset allocation and expanding its range was revered, with others rushing to replicate it. This approach became known as the “Yale Model”, and revolutionized endowment investing.

Swensen understood that a portfolio’s long life significantly enhanced its ability to search for yield beyond public markets. By eliminating the constraints of a reactive, short-term approach, Swensen delved into private assets, which afford greater access to management, and insight into their strategies as well as value drivers. 

He realized that private assets that required rigorous research and have no active exchange, offered a premium to patient investors that could forgo the need for immediate liquidity. 

Seeing higher yields in alternative assets such as real estate, private equity, and natural resources – he aggressively shifted the asset mix.

Today the Investment world is looking at “Alternative Investing” as the core assets of a portfolio. 

About the Author
Dan Dobry was the founder of the Union of Financial Planners in Israel (UFPI), served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and from January 2019 is a member of the Committee for Standards and Qualifications for the European Union (SQC).
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