Return-Driven Investing for the Years Ahead
Modern Portfolio Theory (MPT) has changed little over the last 68 years and has clear limitations that impede the return objectives of modern tech-savvy investors.
The Capital Asset Pricing Model (CAPM) enhanced MPT but did nothing to relieve the uncertainty both individual and institutional investors have regarding the investment process. Intuitively investors understood that investing involves risk and MPT theoretically reduced some of that risk through diversification.
However, as the last several decades demonstrated neither MPT nor CAPM theories did much to mitigate the losses investors incurred.
MPT’s limitations have become abundantly clear.
No longer is the goal “to beat the market” prudent investing. Prudent investors are more interested in investing with a purpose.
Today’s sophisticated investor has a goal-based orientation. They know where they are today financially and where they need to be tomorrow.
Investing “in the market portfolio” doesn’t provide them with the information necessary to determine whether they are making progress toward their future needs.
Post-Modern Portfolio Theory (PMPT) offers investors an alternative by suggesting that there is a specific link between where they are today and where they need to be tomorrow.
PMPT calls this link the ERO – Essential Returns Objective. It is the return linking today’s assets to future goals.
The ERO, Essential Returns Objective, is the client’s DNA. It is used to analyze managers, measure performance, and construct portfolios. It is a known entity whereas the market return is not.
Yogi Berra once said, “You’ve got to be very careful if you don’t know where you’re going because you might not get there.”
MPT’s basis for investing is built around a mean/ variance framework. The investment objective is to maximize the return of the market for a given level of risk.
However, as Yogi Berra indicated if the investor doesn’t know what the return of the market or their tolerance for risk is until after the fact they won’t know whether they are making progress toward their future needs until it’s too late, increasing uncertainty and anxiety.
The market return is irrelevant and risk is not volatility.
However, in the PMPT framework asset allocation is not determined by the market return or the investor’s tolerance for volatility.
It is determined by the ERO – the return needed to take the investor from where they are today to where they need to be tomorrow.
This matrix illustrates MPT’s limitations and PMPT’s advantages for sophisticated return-driven investors:
Advancements in Portfolio Theory Leading to ERO® |
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| Variable | Modern Portfolio Theory | Post-Modern Portfolio Theory |
| Investment Beliefs | ⊗ Believes investors cannot beat the “market” | ⊕ Believes beating the “market” is irrelevant to the investor’s return goals |
| Volatility | ⊗ All volatility is bad, whether upside or downside | ⊕ Downside volatility is bad while upside volatility is good |
| Basis of Investor Decisions | ⊗ Mean return and standard deviation | ⊕ Identify the investor’s Essential Returns Objective (ERO), linking today’s asset position to future goals |
| Investment Objective | ⊗ Maximize expected rate of return for a given level of risk | ⊕ Maximize the potential to meet or exceed the investor’s ERO relative to the risk of falling below the ERO |
| Active versus Passive | ⊗ Active management cannot add value | ⊕ An optimal blend of active and passive management should outperform a portfolio of purely passive managers |
| Current Financial Status | ⊗ Minimally considered | ⊕ Essential consideration |
| Future Financial Needs | ⊗ Minimally considered | ⊕ Essential consideration |
| Risk | ⊗ Risk is volatility | ⊕ Risk is failing to achieve the investor’s goal, their ERO. |
How important is it to achieve the return goals for your investment strategies and have access to the technology that will do the analytical hard work for you in seconds?
Let us demonstrate this invaluable tool for you.
It is time to think differently about your business.
Let us show you a better way with ERO.