What Doing the Laundry Can Teach Us About Investing
One of the most enduring tenets of finance may have passed its prime.
Throughout my career in the financial services industry, the concept of the efficient frontier, first developed in 1952 by Nobel Laureate Henry Markowitz, has underpinned and informed portfolio management and asset allocation – as much, if not more than any other intellectual breakthrough of the last half century.
Conceived as part of Modern Portfolio Theory, Markowitz’s efficient frontier represents the combination of assets that, at any given point of time, will produce the highest investment returns per unit of risk.
“Because Markowitz’s effort was so simple and powerful, it attracted a great number of followers and is still widely used today,” wrote two admirers in a recent academic paper. It became the central tenets of what might be called the golden age of asset allocation, a decades-long period when advisors of all stripes and colors could get paid, and paid well, for the alchemy of constructing portfolios that, at least on paper, promised to outperform less scientific approaches to investing.
But today, new entrants such as “robo-advisors” are disrupting asset management and using low cost efficient frontier algorithms to turn asset allocation into a commodity. Investment professionals are responding by looking for things they can do for their clients that no one else can do (including computers). Helping clients identify life goals and achieve desired outcomes is replacing the construction of investment portfolios as a driver of value. “Goals-based wealth management” and “solutions” are superceding asset allocation and portfolio construction as the future building blocks of wealth and asset management.
In the process, Markowitz’s 1950s version of the efficient frontier is being eclipsed by another kind of efficient frontier – call it the next generation efficient frontier -- the objective of which is to optimize portfolios not in terms of returns per unit of risk, but in terms of the certainty of achieving desired outcomes.
Here’s one way to think of it.
When a consumer walks into an appliance store and buys a washing machine, they expect that washing machine will turn dirty clothes into clean clothes 100% of the time. In fact, they can buy a warranty that more or less guarantees that.
When a consumer walks into a money manager, however, they are asked to accept the investment equivalent of a washing machine that may or may not work as expected. Our industry tells them: “Combine the optimal mix of detergent, water temperature and clothing type and you will have a 50% chance your clothes will come out clean, a 25% chance they will come out dirty, 20 % chance they will be turned a different color, and a 5% chance they will come out shredded.”
Who would buy a washing machine like that? No one.
Yet, in many ways, that’s what advisors and manufacturers of investment solutions have been asking their clients to do for years.
No doubt some readers of this article will question the validity of the washing machine analogy. Investing, they will argue, is a lot more like sailing a ship across open water than doing the laundry. Knowing where you want to go is the first step. Buying the right kind of boat is the next (preferably one with a heavy keel) Equipping it to withstand all kinds of weather and hiring an experienced captain are also important.
Taglines like “Guides for the Journey” - starring the advisor as captain of a seaworthy ship, who can’t control the wind or the waves, but knows how to batten down the hatches in a storm – captures this kind of positioning, which wealth management firms have been offering up for decades.
But today’s consumers of investment advice want more certainty and dependability than that.
They have financial goals, which they often need help articulating, such as generating steady, reliable monthly income to support their chosen lifestyles. Or growing the value of their savings so they have enough money to retire and/or to pay for their children’s education. Or preserving the value of their savings when interest rates rise and stock markets correct.
They want their advisors and investment managers to provide investment and wealth management strategies that offer them a high likelihood of achieving those goals. The Next Generation Efficient Frontier represents in theory the combination of assets, risk management overlays and dynamic tweaking that best accomplishes that.
It’s not nearly as simple or as straightforward or as easy to execute as the risk/return efficient frontier of the 1950s. But then, neither is the world we are living in today.