The real trouble with most portfolio theory is the odd combination of rational and irrational actors within the market as a whole. In any given equity, sector or market there will exist both large-scale institutional investors who rely on certain benchmark analysis to determine their moves. Some will be noisy and public like Buffet and Icahn, for example, and some will be very quiet and private, like certain pension plans and such.
That’s fine, there’s a certain predictability to their behavior.
The problem becomes when you factor in the enormous growth of the small scale investors (say those with less than one million dollars to invest). Those investors tend to be more unpredictable in their behavior and can throw off most predictive models for essentially random reasons. Both emotion and reason exist inside their investment decisions. They also tend to be stampeded by the herdlike nature of the financial media (I spent time as a columnist for one of the biggest stock analysis firms around. I know whereof I speak on this). It can be confusing.
To a certain extent I agree that index funds can be a safe spot in which to exist, especially if you don’t wish to do the research on your own. However, it’s not always the best return. The numbers you hear about the frequency of stock pickers being able to outperform the market (I believe that was mentioned upthread) is a bit misleading in my experience.
At this point I know a godawful number of brokers, both in my firm and outside. The biggest problem I have in the industry is the acceptance most of them have with the decisions their firm hands down. I see this in two ways:
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I know of several large firms in which calls for investments are made by national-level analysts. That is - and I was promised this as an advantage if I switched to this big bank - I’d get to work in the morning and I’d have a message from the national HQ with what stocks I should be calling on that day. I was promised a client base of more than 5000 households that I could then spend the entire day calling and trying to get to buy that stock. The kicker: whatever stocks were brought out from the HQ were ones that corporate had gone into the day or night before and it would be my job to move then, regardless of whether the stock was a good investment fit for the clients. This almost guarantee that the investment rep won’t outperform the market because he or she isn’t making decisions based on the suitability of the investment for the client. Therefore the clients portfolio won’t be balanced by risk, sector and other factors and underperformance is almost a lock.
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The other, more subtle problem I see in my fellow brokers - and this applies to those at my firm as well as others - is that a lot of brokers just don’t actually think about economic conditions and what that means for their clients. This is what I mean about concern for those who work from model portfolios. These brokers accept the model portfolios, build them and leave them be. That means they’re using a one-size-fits-all method (or about five sizes if their model portfolios use risk assessment as a basis) and that leads to an inflexible investment strategy. The companies inside the S&P, for example, will approach the world flexibly and with intelligence, therefore portfolio models should as well. It is my belief that there are too many factors to blindly use any portfolio model.
For me, I review each of my client’s portfolios at least once per month (I manage about 400 households right now) and spend time thinking about whether their current investments match both the risk sensitivity of the client (everyone’s different) and current economic conditions.
Example, in today’s current rising interest rate environment, bond funds are losing value. Not all, but many. For clients with a longer time horizon a model portfolio will allow for a hold through this sort of thing. Using a more active approach, like I practice, and using rights of aggregation, my clients move out of bond funds and further to the right on the risk chart to take advantage of new conditions.
Illustration:
Let’s assume that we have a client, Mr. Smith. Smith has $100,000 spread evenly amount five risk categories (note: don’t do this), all in a single mutual fund family.
Conservative: $20,000
Moderately Conservative: $20,000
Moderate: $20,000
Moderately Growth: $20,000
Growth: $20,000
Simple enough. But in today’s environment, I’d move some of his more conservative money lower on the risk curve (I normally say right and left but I couldn’t get the spacing right). Therefore, in today’s climate I’d exchange him into:
Conservative: $10,000
Moderately Conservative: $15,000
Moderate: $30,000
Moderately Growth: $25,000
Growth: $20,000
Still, $100K, but now better positioned to take advantage of a weakened bond market, and therefore an increasing equities market.
Aha, I hear you say, but doesn’t that cost Mr. Smith, all that moving? Nay, says I. Note that I used the word ‘exchange’ up there. With certain mutual fund families, I can move funds inside the families at no charge. So Mr. Smith may have paid an upfront charge to get into the family at his initial buy, but subsequent moves that are made come at no charge provided the money stays inside the fund family. So imagine all of those funds (conservative, growth and so on) are inside the “Mutual Funds are Great!” family. Making that adjustment outlined above in which $15,000 was moved came at a cost of nothing to my client. Even my time isn’t charged for the work. It’s all part of the service.
There’s also rights of aggregation as mentioned up there. That is the fact that, as clients invest more and more money into a specific fund family, the cost of investing more declines. For example, the fictional fund family might show breakpoints at $50K and $100K. So when Mr. Smith invested his first $25K he paid X% as a sales charge. The investment that got him past $50K was charged X-0.5% and the investment that got him to $100K might be at X-1.5%. Numbers made up but you get the idea. Mr. Smith can ALSO get those discounts simply if he COMMITS to reaching such a number in the next year. So if he signs an agreement to get to $50K by the end of 12 months, he’ll save on his sales charge even on his investments under that breakpoint.
Anyway, index funds can be a good basis for someone who doesn’t want to get too involved. I don’t disagree, but active buy-and-hold can get you an extra couple of percent provided you approach it properly.