Assuming you believe the underlying assumptions (and they very well may not be true), modern portfolio theory allows you to build a mathematically ideal portfolio for a given amount of risk.
The math behind MPT might be hand waved as followed: goal seek a maximum portfolio return by combining assets with minimal correlation under a fixed risk scenario. In the end, you will have portfolio that will give you the maximum theoretical return for your selected amount of risk.
In practice, outside of running a hedge fund, or a mutual fund with explicit investment guidelines (e.g. we invest in emerging market energy companies), a responsible asset manager has no choice but to follow MPT. In other words, if you are not a specialized fund, there is no mathematical justification for deviating from an MPT constructed portfolio. By definition, any deviation from a MPT balanced portfolio means you have either a) taken on more risk than necessary or b) reduced your potential return or c) do not believe in the underlying assumptions of MPT.
So what is the amateur person worth $25M to do today? As with all things, you should seek professional advice. There are many nuances of tax efficiency, estate efficiency, asset protection, personal needs, etc. that a professional advisor should guide you through.
Apparently the folks at WealthFront and FutureAdvisor are selling MPT driven portfolios to employees of SF bay area tech firms.
edit: As a couple of users point out below, there is controversy over the effectiveness of MPT including: whether the models effectively capture the distribution of risk vs return and whether the values desired by the models can be calculated with proper accuracy. PMPT (post-modern portfolio theory) builds upon MPT. Lastly there are critics such as Nassim Taleb (of Black Swan fame) who find some of the core assumptions flawed.
> So what is the amateur person worth $25M to do today?
A person worth $25M already has it made. They could light $1,000 a day on fire for the rest of their lives and still not go broke. Their investment options aren't really so interesting because only deliberate idiocy could destroy their retirement.
I think a more useful question is, what is the amateur person worth $25K to do today? Or the young person with negative net worth? The usual "just dump it into the stock market and pray" seems very risky. Sure, long-term the overall stock market expected to go up on average, but that is if you can survive the variance. Netted out over the years, I'd guess that I've pretty much lost money on the stock market, and I'm skeptical of someone with a simple answer that amounts to "hand your money to Wall Street".
> I think a more useful question is, what is the amateur person worth $25K to do today? Or the young person with negative net worth? The usual "just dump it into the stock market and pray" seems very risky. Sure, long-term the overall stock market expected to go up on average, but that is if you can survive the variance. Netted out over the years, I'd guess that I've pretty much lost money on the stock market, and I'm skeptical of someone with a simple answer that amounts to "hand your money to Wall Street".
The big thing is to avoid the fees. The average money manager performs averagely, so unless you have some way of picking an above-average one, the fees you're paying are literally handing money to Wall Street. You're right to want something anticorrelated with the stock market, but everyone wants that, and paying a 2% fee to "diversify" probably costs more than you gain. I think there's some merit in the "fifty-fifty" approach - half your investment in an equity index fund, half in a cheap bond fund. But more exotic asset classes probably cost more than they're worth.
The other thing is to make sure your exposure to the housing market is appropriate (indeed I've heard a three-way split suggested). If you're paying a mortgage you'll do better to pay that off quicker rather than invest in stocks or bonds. If you're wealthy enough to own outright you want some of your "excess" wealth (over what you need to own the house you want to keep) in housing, either by buying another one to rent, or by having a big enough house that you could downsize if you needed to. If you're young and renting is the really tough part: if you buy then you're insulated from the market, but relying on your ability to repay the loan. But I guess books have been written on this already.
>So what is the amateur person worth $25M to do today? As with all things, you should seek professional advice. There are many nuances of tax efficiency, estate efficiency, asset protection, personal needs, etc. that a professional advisor should guide you through.
While this is true, the problem that most advisors that a $25MM net worth individual has access to are mostly duds and/or salesmen.
Identifying true value add advisors is easier said than done, imo.
Personally, i think that's more of a problem for the guy with the $500k retirement account. You will have no shortage of white gloved managers eager to help you invest your $25M. But anything short of $1MM you're solidly in Edward Jones territory. At that point you're probably better off keeping it stuffed under your mattress.
If you're not a multi millionare, IMO it's worth the time to learn how to manage your own money. Because nobody will ever care as much about your money as you will. A good place to start IMO is by subscribing to the TastyTrade podcast. It's the only investing infotainment I've found that treats the listener like an adult and an equal.
IMHO, the quality of people you will find at your local retail branch of an ibank (think BoAML, JPMChase, WF/Wachovia, etc.) is still very shoddy and suspect. These are the channels that people have immediate access to and think of visiting, even if you have $25MM. For these retail operations, iirc the threshold is $50MM before you are shipped off to a proper PWM team at HQ.
>You will have no shortage of white gloved managers eager to help you invest your $25M.
How do you know which while gloved manager is actually any good though, assuming that the $25MM guy is quite naive about investment management? I believe that the small time millionaire must be up to speed on investing basics just as much as the $500k guy, in order to be able to discern the competence of his managers.
I generally agree with jhulla's advice of going through a good estate planning attorney or accountant to find decent people. If you have a network of rich friends (which you can probably make in a few years after making your $25MM by plugging yourself into the right circles), but barring this (or even if you do manage this), I insist that even the rich guy needs to know at least the basics.
At a minimum you should get a "fee only" adviser who has a fiduciary duty to you. You can still get bad advice, but at least you won't get corrupt advice.
You need a good estate planning attorney (ask rich friends), and a good accountant (ask rich friends), and a good financial advisor.
Of these three, if you believe in MPT, the financial advisor is simply a coin-operated sales guy. At a 1% fee against $25 million, your business represents $250K/yearly. That is a solid sum of money to any business.
But practically speaking, what is that financial advisor going to sell you? Odds are after you get past the glossy color printed custom, just-for-you, spiral bound investment plan, you will see a custom portfolio that will be assembled with MPT. This is the product that sell every day to every other $25 millionaire that walks in the door.
Sure, you get to tune the outcome based on your risk threshold, or other biases you may have. But unless you are rolling your own investment strategy based on your own perception of future returns across asset classes (in other words running your own micro-hedge fund) you are buying MPT.
Are there managers and funds that beat everyone else year in and year out. Yes there are. Why don't you get the chance to park your $25 million with them? Because even the choice of parking your funds with them is bound by the math of MPT.
Agreed. This is the only thing I could come up with that would reasonably ensure that I would be talking to someone decent.
Offtopic, but it is my belief that one of the strong factors in the perpetuation of wealth and associated wealth disparities in society is exactly this kind of information and knowledge asymmetry in the population, from access to the best advice (networks or simply the funds to gain access) to the osmosis-like uptake of information throughout one's childhood when raised in an affluent family/neighborhood/environment.
>the financial advisor is simply a coin-operated sales guy
Agreed. this is absolutely the mindset I tell all my friends to adopt, and to not be mislead by the title of "advisor", since they are anything but.
>Odds are after you get past the glossy color printed custom, just-for-you, spiral bound investment plan, you will see a custom portfolio that will be assembled with MPT.
Partially agreed.
Most of the time, I agree that what will be pitched is a cookie cutter MPT set of assets/funds that, while often of somewhat marginally unideal quality, will generally get the job done. However, I have* seen and heard of absolutely horrible plans being thrown at naive new wealth people, and while "odds are" (as you say) this won't happen to you, it's still a non-neglible probability that you get wrapped up with some truly sleazy operations.
That being said, your average American PWM firm/team/branch isn't likely to totally come after you like this. I think this is more likely to happen in Asia or Asian firms in the west.
How is MPT supposed to determine the risk in an individual security? The human element, and the number of variables under consideration seems to pretty much require MPT to be restated as "an approximation to a mathematically ideal portfolio for a given amount of risk". On the other hand, I don't know MPT at all. Can you give any info on how risk is quantified so well?
You'll want to check out Steve Keen, of "Debunking Economics" fame, for the gory details. He has a blog (debtdeflation.com or something) with a couple of finance class videos on it, and he runs or used to run a talk all over, a version of which you'll find in the Google Talks channel.
In short though, the entire thing is based on the idea that finance is based on guassians, whereas the evidence overwhelmingly suggests it's based on power laws instead. (And intringuingly, the consequence of the latter would mean that portfolio risk increases when you're diversified in many asset classes.)
The primary question is this: do we truly have models that can predict future asset correlations. In other words, are our assumptions about distribution of returns valid. Behavioral economics suggests that individuals react differently than mathematically predicted.
Personally, I think the biggest problem with any ideal portfolio allocation tool are black swan events (Taleb).
> I think the biggest problem with any ideal portfolio allocation tool are black swan events (Taleb).
Yes. Black Swans are certainly a problem. It's insane to think that investment returns are anything resembling a Gaussian distribution. In the financial crisis of 2008-2009, people were using phrases such as "a 9 sigma event" to describe the markets.
Wrong! Basically THERE'S NO SUCH THING AS a 9 SIGMA EVENT. Wikipedia gives the probability of a 6 sigma event as 1 in 500 million. So it the epitome of arrogance to think that we're so "special" that we just happened to be alive during a 9 sigma market move.
What it all really means is that the markets do not behave the way lazy eggheads want them to. Everyone understands Gaussian distributions and standard deviation. So they are eager to use that math where they shouldn't.
I'm sure you know all this. But for those people who aren't familiar with Taleb and want to read more, he wrote three pop books about it:
George Soros' perspective is grounding. Markets are moved by people with incomplete knowledge. The entire field of economics is based on a false analogy with Newtonian physics. There is no equilibrium, no mystical balancing force underlying the economic universe. Just a whole bunch of relative idiots trying to get rich for free.
Are these works (esp the latter) accessible to people with no economics background, but a decent foundation in maths (calculus & algebra) and basic statistics (distributions etc)?
Yeah, this whole "a responsible asset manager has to use MPT" is completely not true. A responsible asset manager has to consider risk and return, of course, but how they measure and evaluate risk and return is an art as much as a science. MPT-driven portfolios have been shown to underperform more naive formulations, mainly due to model risk and mis-estimation of parameters.
The math behind MPT might be hand waved as followed: goal seek a maximum portfolio return by combining assets with minimal correlation under a fixed risk scenario. In the end, you will have portfolio that will give you the maximum theoretical return for your selected amount of risk.
In practice, outside of running a hedge fund, or a mutual fund with explicit investment guidelines (e.g. we invest in emerging market energy companies), a responsible asset manager has no choice but to follow MPT. In other words, if you are not a specialized fund, there is no mathematical justification for deviating from an MPT constructed portfolio. By definition, any deviation from a MPT balanced portfolio means you have either a) taken on more risk than necessary or b) reduced your potential return or c) do not believe in the underlying assumptions of MPT.
So what is the amateur person worth $25M to do today? As with all things, you should seek professional advice. There are many nuances of tax efficiency, estate efficiency, asset protection, personal needs, etc. that a professional advisor should guide you through.
Apparently the folks at WealthFront and FutureAdvisor are selling MPT driven portfolios to employees of SF bay area tech firms.
edit: As a couple of users point out below, there is controversy over the effectiveness of MPT including: whether the models effectively capture the distribution of risk vs return and whether the values desired by the models can be calculated with proper accuracy. PMPT (post-modern portfolio theory) builds upon MPT. Lastly there are critics such as Nassim Taleb (of Black Swan fame) who find some of the core assumptions flawed.