Investment Strategies For Retirement Based On Modern Portfolio Theory

After publishing my post, The Best Asset Allocation Of Stocks And Bonds By Age, I decided to do a comparison of what I recommend versus what digital wealth managers like Personal Capital recommend. 

Not only has Personal Capital developed a great free app for managing your net worth that most of you already use, it also manages over $10 billion in client assets.

For those who don't know, from 2013-2015 I consulted for them in their marketing department and still meet up once a quarter since they're in San Francisco. Thus, I'm very familiar with Personal Capital's people and product.

Its board of advisors include:

Harry Markowitz, recipient of the 1990 Nobel Memorial Prize in Economic Sciences. He pioneered work in portfolio construction and is known as the “Father of Modern Portfolio Theory.” Markowitz received his Ph.D. from the University of Chicago and is currently a professor of finance at the Rady School of Management, University of California, San Diego. His Modern Portfolio Theory is central to the design of Personal Capital's portfolios.

Shlomo Benartzi, a renowned behavioral economist. He received his Ph.D. from Cornell University, and is currently a professor and co-chair of the Behavioral Decision-Making Group at UCLA's Anderson School of Management.

Together they advise a team of portfolio management professionals and have created several long-term investment strategies. But first, let's have a brief overview of Modern Portfolio Theory.

Investment Strategies Based On Modern Portfolio Theory

The efficient frontier is a concept in modern portfolio theory introduced by Harry Markowitz and others in 1952. If there are two portfolios that offer the same expected return, investors will prefer the less risky one. If the price is the same, wouldn't you buy the exact same house with panoramic ocean views over the one with a view of another building? Of course you would.

In Modern Portfolio Theory, everything is RATIONAL, which is why I'm such a big fan. Everybody here wants to improve their personal finances, which is why none of you are on Buzzfeed killing brain cells. Nobody here thinks they'll have guaranteed employment for life, which is why you are building as many income streams as possible.

Unfortunately, there are a lot of irrational people out there who believe you can get ahead without putting in the effort. I've even met some C students who think they deserve A lifestyles. No wonder credit cards are such big business. They allow consumers to realize their delusions.

According to the Efficient Frontier chart below, optimum portfolios track the hyperbola. Portfolio mixes under the hyperbola are inferior because they either offer the same return with more risk, or they offer less return for the same risk. Portfolios above the hyperbola don't exist because unicorns don't exist. The markets will arbitrage everything away.

Now that we have some understanding about the basics of Modern Portfolio Theory, let's look at Conservative, Moderate, and Aggressive investment strategies recommended by Personal Capital under the guidance of Harry Markowitz himself.

Investment Strategies For Your Retirement Portfolio

Conservative Investment Strategy

For those who are already financially independent or soon will be, this conservative investment strategy is my favorite. It allows you to sleep well at night and let you focus on life instead of your portfolio.

People following this strategy are usually around 60, but if you've already achieved financial independence at a younger age, consider following this asset allocation. Note 48% of the investment portfolio is in bonds and 2% is in cash to take advantage of any opportunities.

In the past, we've discussed how large endowments and very wealthy individuals invest a heavy portion of their portfolio in Alternatives (50%+) to provide diversification and hopefully higher returns due to inefficient private markets.

The 10% Alternatives weighting is a common weighting private wealth advisors recommend for high net worth clients. Thus, the question to ask is: what kinds of alternatives is one investing in. The answer is usually private equity, hedge funds, venture capital, and real estate.

The blended average weighting of all my public investment portfolios (Rollover IRA, Solo 401k, SEP-IRA, After-Tax Accounts) has a fixed income weighting of 40% – 50%.

All I'm shooting for is a 4-5% return, or 3X the risk-free rate. I'm looking to preserve capital that took 20 years to build and not worry about my investments as much. Instead I'm focused on actively building new active income via entrepreneurial activities.

Moderate Investment Strategy

With a 25% bond weighting, this moderate investment strategy is created for people who are still aggressively trying to save and build capital, but want less volatility due to growing financial responsibilities e.g. mortgage, wedding, spouse, kids, overpriced car, parents, etc. This portfolio is designed for people who are typically between 30 – 50 and plan to work a day job into their 60s.

The assumption behind holding international stocks is that there may be more opportunities for growth and therefore profit compared to domestic stocks. For example, China's annual GDP is supposedly growing anywhere between 6% – 8% compared to just 1% – 3% for US.

But sometimes you lose, like when the London FTSE 250 declined by 12% versus just 3% for the S&P 500 after Brexit. If valuations are reasonable, allocating roughly 20% of your portfolio into international index funds and stocks may be a good idea.

Remember, what is considered international to us is considered domestic to others. For example, for a moment pretend you're a Canadian investor. Your portfolio probably consists mainly of Canadian equities and perhaps small international investments in the US, Asia, and Europe.

In other words, we tend to invest in the places we know best. Never invest in what you comfortably don't understand. This is called country investing bias.

Aggressive Investment Strategy

This investment strategy is what most investors in their 20s and early 30s pursue. Returns are strongest in a bull market and terrible in a bear market. Yes, bear markets do happen as we saw most recently from 2000 – 2002 and 2007 – 2009.

While my asset allocation chart has a 100% equities allocation up to age 30, I'm nervous for anyone whose net worth is made up entirely of their public investment portfolio.

Having a 3% allocation in bonds and 0.5% allocation in cash doesn't provide much protection against declines. Nor does it produce much income. Thus, if you want to be aggressive, you might as well go all-in 100% equities. I would consider the 3% bonds weighting as part of a 3.5% cash allocation for equity buying opportunities.

For those who follow this Aggressive Investment Strategy please do not confuse brains with a bull market, especially if you're 35 years old or under. It's very hard to know your true risk tolerance when you haven't lost much money on an absolute level or large percentage basis (30%+).

Come up with a better dollar cost averaging strategy and continue to actively grow new income streams.

Your Investment Portfolio Should NOT Equal Your Total Net Worth

When pure digital wealth managers or financial advisors with incomplete information give you investment recommendations they often do so based on the mistaken assumption that your investment portfolio with them equals your entire net worth. For most people, this is clearly not the case.

For example, public investments in stocks and bonds make up roughly 25% of my net worth. ~38% of my net worth is comprised of physical real estate. Another ~12% of my net worth is made up of risk-free assets such as CDs.

Finally, the remaining 25% of my net worth is made up of my online business. My net worth is diverse because like most people, I have diverse interests. Life is not just about making money to invest in stocks and bonds!

If I had 50% of my net worth already in CDs and money markets because I plan to buy a house within the next three years, then an advisor recommending any cash weighting in my investment portfolio may be suboptimal.

If an advisor doesn't realize you have 70% of your net worth tied up in speculative real estate projects, perhaps following an Aggressive Investment Strategy of 90% equities is the wrong move.

Without knowing your entire net worth makeup, it's difficult for pure digital wealth managers to make the most appropriate investment strategies. If you don't want to be completely forthright with your financial advisor about your overall wealth, then it's up to you to first analyze your own net worth and then accept or disagree with their recommendations.

The good thing about Personal Capital is that it is a hybrid advisor with technology to leverage and people to talk to about your financial situation. The bad thing about Personal Capital is it charges more than its 100% purely digital competitors to manage your money because financial advisors cost money.

Luckily for all of us, they have free wealth management tools for everyone to use whether you are a client or not.

Whomever you decide to invest your money through, make sure they know your entire net worth composition. Bare all! If you decide to invest all the money by yourself, be sure to consider your entire net worth when allocating weightings.

Differences With My Asset Allocation Weightings

There is no one size fits all investment strategy recommendation. Everybody has different financial goals and liquidity needs. Further, within the overall split between stocks and beyonds there are obviously many different types of stocks and bonds to choose from.

My asset allocation recommendation is based on Harry Markowitz's modern portfolio theory, but has some key differences.

1) New normal.

I take into consideration the new normal of highly interconnected markets, more volatility, lower inflation, and lower interest rates. Further, markets are now highly efficient thanks to technology, thereby limiting successful arbitrage opportunities.

In other words, the returns of the past will be harder to replicate today. Yet with massive corrections every 5-10 years, risk seems to have stayed the same or increased.

Remember, Markowitz came out with his Modern Portfolio Theory over 60 years ago. The people still sticking with a 4% safe withdrawal rate in retirement are not changing with the times.

2) We are living longer.

In 1952, life expectancy was about 60 in America and 65 in Europe. Someone born today expects to live past 80. Longer lives mean more risk is needed to generate higher returns. A 50-year retirement could be a reality for millions of people born today!

At the same time, however, longer lives mean that if you take on too much risk, there's a greater chance for you to be screwed unless you jump off a bridge. Given its better to be safe, than broke, my asset allocation recommendation is more conservative once you've reached your financial nut.

3) More opportunities to earn money.

In the past, once you were retired, to survive you relied on Social Security, savings, investment income, and maybe a pension. Today, it's possible to retire by age 40, live off your multiple income streams, and do some consulting or gig economy work to make up for any financial shortfalls. 

The Affordable Care Act has given middle income and lower income people more work flexibility to be untethered from a job they dislike because they no longer have to worry about medical bankruptcy with subsidized coverage. It's been 4.5 years since I held a day job and I can unequivocally say there are endless ways to earn money thanks to technology.

When it comes to investing in public markets, it no longer pays as well to take on the same level of risk as before. Look at the 10-year bond yield at ~1.5%. Look at the average annual return of the S&P 500 over the past 15 years versus the previous 15 years. Look at the dearth of IPOs as private companies stay private for longer. So many signals are telling us to be more conservative.

For these three reasons, I recommend everybody build their financial nut as soon as possible and then get as close to a 50/50 stocks/bonds allocation to preserve capital and keep the passive income flowing. You don't have to wait until 65 to get to a 50/50 weighting if you amass your enough money at a younger age.

Stay On The Ball With Your Retirement

Don't view public equities as your retirement savior. View public equities as only one retirement engine out of hopefully four or more.

Your other engines should include real estate, alternatives, Social Security and your own business where you can really make a killing if you get things right. But if all you can manage is investing in stocks and bonds, then so be it. It's still better than just hoarding cash all your life.

To get a free analysis of your investment portfolio(s), link your investment account(s) and then click Investment Checkup under the Advisor Tools tab in the Personal Capital app.

You'll see where your portfolio stands on the Efficient Frontier and how your current allocation matches up with your target allocation recommendation.

The next 10 years likely won't be as good as the previous 10 years. Track your finances like a hawk!