What methods and strategies does your money manager use for your portfolio? This is a question that most investors cannot answer.

Most managers out there are using what I call a “static model based approach” which has been developed using principles of Modern Portfolio Theory (MPT) and Asset Allocation.

Modern Portfolio Theory – MPT: tries to maximize portfolio return for a given level of volatility (sometimes called risk).  The idea is that at any given time different asset classes will be performing better or worse than other asset classes and by having a mix there will be reduced volatility while still getting the same long-term performance.

Asset Classes: the three most basic asset classes are stocks, bonds, and cash (stocks = equities, bonds = fixed income). Those three asset classes can be broken down into smaller sub-categories or sub asset classes. Example: stocks can be broken down to: foreign, US, growth, value, large cap, small cap, technology, consumer staples and on and on.

How it works for you as the client: The money manager or others within the firm (more often others) create various model portfolios typically using mutual funds or ETFs. Client fills out risk questionnaire, which matches them with a particular model. Client’s portfolio is built out to mirror the model and then rebalanced on some set time schedule, usually annually, semi-annually, or quarterly.

Below are examples of 100% equity portfolios, using the above methodology. Using mutual funds or ETFs the manager creates portfolios based on static percentages using many or few categories of stocks. As you can see the number of asset classes/holdings can be as few as two, or infinitely many. The key is to keep the holdings the same, and rebalance to the set percentages (not necessarily equal) at regular intervals.

Example 1:
50% – US Large Cap
50% – Foreign Large Cap

Example 2:
25% – US Large Cap
25% – Foreign Large Cap
25% – US Small Cap
25% – Foreign Small Cap

Example 3:
10% – US Large Cap Growth
10% – US Large Cap Value
10% – Foreign Large Cap Growth
10% – Foreign Large Cap Value
10% – US Small Cap Growth
10% – US Small Cap Value
10% – Foreign Small Cap Growth
10% – Foreign Small Cap Value
10% – US Mid Cap
10% – Foreign Mid Cap

Is this MPT ingenious? Yes.
Is MPT too conceptually complex for average investors to implement? No. Can the average investor successfully implement a strategy like this? No; year after year countless studies continue to show that the vast majority of investors may comprehend these investing concepts, but are unable to implement them successfully.

Drawbacks: There are several drawbacks and critiques to be made of MPT, I will make one. The theory is based on the assumption that the future results will be the same as the past results.

My take is that if an investor has the mental and emotional discipline to stick with a plan, then they may consider using the principles of MPT and Asset Allocation to self-manage as an alternative to hiring a professional at 1-2.5% (not counting fund expenses) that is using the same principles. Keep in mind that there are countless other investment methods and strategies out there. It is just my experience that most of the money managers are using a variation of this methodology.

Understanding these principles is important for all investors.

Wyatt do you use the above outlined approach to manage client’s portfolios? No, I use an approach I refer to as tactical portfolio management. I will detail my approach in the future.