When coming up with a portfolio allocation for clients, it can be tempting for advisors and portfolio managers to approach the problem mathematically. Numbers are objective, and optimizing a portfolio based on specific input parameters and defined return requirements should, rationally, be the right approach.
But according to Joachim Klement, CFA and head of Investment Research at Fidante Capital, the optimal solution is often far from the best one for investors. “The problem with optimal solutions in the investment world is that they are very sensitive to the input parameters,” he wrote in a recent blog post published by the CFA Institute.
He pointed out that the sensitivity of a Markowitz portfolio optimization to return assumptions is 10 times its sensitivity to volatility assumptions; it’s also 100 times more sensitive to return assumptions than the correlation assumptions. But in practice, returns are much harder to predict than volatility or correlation, and estimation errors for return forecasts are often so large and robust that reliably calculating the optimal portfolio would practically require thousands of years of data.
“Yet, so many consultants, chief investment officers (CIOs), and wealth managers insist on optimizing a portfolio based on a set of assumptions about the future,” he wrote, adding that this “black box” approach doesn’t work well with clients. A portfolio manager and a client usually go into long discussions on why equity returns should reach, say 10%, bonds 3%, hedge funds 5%, and so on. But the client, usually a layperson with a shallow knowledge of finance and portfolio theory, never understands how the assumptions yielded the proposed allocation. That means when the realized portfolio returns fail to reach expectations, clients drop the black box and switch to another portfolio.
Klement cited his experience with a previous employer, where they found that the average client investment period in multi-asset portfolios with varying strategic asset allocations was just around 18 months. “The outcome for investors was worse performance in the long run than if they had just stuck with a specific strategy,” he said.
The best portfolio, he concluded, is the one that a client can stay in as the market moves up and down. And the way to do that is to frame the roles of different assets in the portfolio not relative to volatility and return, but relative to the investor’s goals. Equities, or private equity, aim for long-run growth; this can only happen, Klement said, when investors feel safe enough to hold them even through bear-market declines of 20% to 50%. That sense of security comes from having enough cash and government bonds to guarantee that obligations can be met as equities regain their stride. Safe but low-return investments can be supplemented with income-producing or inflation-linked asset classes like property or infrastructure.
This thought process, Klement said, has led to liability-driven investments among pension funds; in the private wealth-management world, approaches like Ashvin B. Chhabra’s three dimensions of risk have long been discussed and occasionally implemented.
“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box ‘optimal portfolios,’” Klement said, urging financial professionals who take their fiduciary duty seriously to consider switching their approach.
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