An Easier, Better Portfolio Design Approach
Dynamic Investment Theory introduces fundamental change in the way investment portfolios are designed. One of our goals when searching for a better approach to investing was to remove subjective, human judgments from the design process and replace them with far more reliable objective observations of market movements. We wanted to reduce the "human error risk" element as much as possible.
DIT meets this goal by allowing portfolios designers to choose which Dynamic Investments to use in a portfolio but the ultimate selection of which ETFs are purchased and held by the portfolio is made by market movements - e.g. an objective decision based on observation of market trends.
I will illustrate the difference using two diagrams presented below. This fundamental change in how portfolios are designed represents a huge advance forward in the world of investing.
How Portfolios Are Designed Today
Today, and for the past 60+ years, investment portfolios have been designed using a process dictated by Modern Portfolio Theory (MPT). It was discussed on the Home Page of this site. This is a theory that was introduced to the market in 1952 and is rapidly becoming obsolete.
Here is a diagram of the portfolio design process using MPT methods.
Here are the steps in the MPT portfolio design process corresponding to the numbers on the diagram.
Step 1, The Goal. All portfolio designs start with a goal. In the MPT world the goal is always to build a portfolio that matches the investor's risk profile. So, if you are the investor, the designer first tries to determine your risk tolerance via a series of questions; questions that virtually no individual is prepared to answer with any degree of accuracy. Yet your answers to these questions will shape your portfolio and determine your financial future. Thus in the MPT world the process of designing your portfolio starts bad and then gets worse.
Step 2, The Investments. Virtually all financial advisors today will recommend mutual funds for your stock and bond portfolio components. Typically they have complete discretion on which ones to recommend and because most are also sales people they are incentivized to sell those with the highest commissions. This may not be in your best interest, but you probably have not been trained how to evaluate these recommendations. So you buy without question.
Step 3, Market Analysis. While meeting your risk tolerance level is the prime goal, good advisors will also look at expert market analysis to determine which type of bonds and stocks to recommend for your portfolio. In boom times, small-cap stocks tend to deliver higher returns than large-cap stocks. And there are a full range of bond choices as well. Again, this is all a subjective decision and wide open to human-error risk.
Step 4, Select Investments and Purchase. With the above Steps taken, the portfolio designer is ready to implement your portfolio by first getting your approval and then purchasing the recommended mutual funds. Your portfolio is now in place.
Step 5, Manage the Portfolio. MPT provides absolutely no guidance for how to manage your portfolio on an ongoing basis. Once it has informed the designer on how to allocate money to your mutual funds in order to match your risk tolerance level, that's it! So, MPT portfolios owners simply told to buy and hold it for the long term, regardless of market conditions. Advisors may suggest a periodic review of your portfolio (e.g. yearly or semi-annually) but this activity is not suggested by any MPT rules - it is at the discretion of the advisor and often doesn't happen at all. This is where your wealth is in danger.
Summary. MPT portfolios are relics of the past but still used almost universally today. The design process is rife with subjective, human judgments at virtually each step of the design process and this leaves the portfolio (and your wealth) wide open to bad data, poor analysis, sales bias and even scams and fraud. In addition because MPT dictates that a portfolio hold both winning AND losing investments at one time to mitigate risk, MPT portfolios provide mediocre returns at best and at high risk.
This type of portfolio needs to be killed off. But what replaces it? The answer to this question is next.
How Portfolios Will Be Designed in the Future
In the future Dynamic Investment Theory (DIT) world of investing the portfolio design process will be much simpler and produce portfolios that provide far higher returns with less risk. It does that by dramatically reducing the human-risk factor and creating portfolios that are sensitive to market movements.
Here is a diagram of the DIT Portfolio design process:
Here are the Steps in this simplified portfolio development process:
Step 1, The Portfolio Goal. The goal of all Dynamic Investments is to buy only equities that are moving up in price and to avoid those that are trending down. This is a universal goal that all individuals want to achieve. Thus, there is no need to customize a DI-based portfolio to meet any investor's risk tolerance level, thus removing a large area of subjective judgments and human-error risk from the portfolio design process. In stark contrast to MPT, the DIT portfolio design process starts good and gets even better.
Step 2, The Dynamic Investment Catalog. Portfolio designers of the future will not look at single ETFs as the starting point for building an optimal portfolios. They will look at combinations of ETFs in the form of Dynamic Investments. And since DIs are "products" without the need for customization, the designer of the future will have access to DI Product Catalogs that are issued by companies and/or individuals that have been trained by the NAOI on how to create optimal DI products. The NAOI currently has a DI Product Catalog containing "off-the-shelf" DIs that have average annual returns over the past decade! In the future other companies such as the top ETF developers will have their own DI product catalogs. And as discussed here, DI products can come in the form of standalone DIs or DI Portfolios. Yes, a DIT designer can create a portfolio of portfolios very simply and easily. It boggles the mind.
Step 3, Select DI Products and Implement. From the DI Catalog the DIT portfolio designer will select from one to three DI products for implementation. Notice that I did not say "for purchase." DIs contain multiple ETFs as purchase candidates in their Dynamic ETF Pool. The market signals which ETFs to purchase based on market trends as discussed in Step 6, below. Thus, in this step designers are NOT selecting single ETFs, they are selecting groups of ETF candidates within a DI that has a proven record of high performance and low risk as described in the DI Product Catalog.
Step 4, Purchase ETFs for the Portfolio. Steps 4 and 5 are automatic. One element of the implementation in Step 3 is setting up an environment in which each DI reviews its DEP and signals for purchase the one ETF that is trending up most strongly. This is the ETF that actually goes into the new portfolio and is held until the next Review period. No human decisions are involved here; the market decides which ETFs to buy and sell. This process takes a huge area of human, subjective decision making risk out of the process. Studies have shown that the "market" is far better at predicting future market movements than any one or group of analysts.
Step 5, Manage the Portfolio. As discussed above, MPT sets no rules for the ongoing management of an MPT portfolio other than to just buy and hold it without regard for changing market conditions. DIT sets very firm and concise rules for how a DIT-based portfolio is to be managed. The DI designer (not the DI portfolio designer) specifies a periodic review period for each DI in the portfolio when its DEP is ranked to find the ETF candidate trending up most strongly. This is the one that is bought and held until the next period. In a DI portfolio with multiple DIs, each will deliver its own ETF to the portfolio of actual purchases. All that the portfolio manager does is make sure that the trades being signaled are made. But, of course, this can all be automated. Again, we have removed virtually all human judgments from the portfolio management process and eliminated that massive risk factor!
Summary. All elements of the DIT portfolio development process are targeted at taking full advantage of the positive returns that the market offers somewhere at all times. And finding and capturing these positive returns is all based on objective observations of market trends, no human judgments are allowed. As a result, DIT portfolios are able to produce returns with low risk that MPT portfolio advocates will say are impossible. As you have seen on this site, returns of 20%+ per year for long periods of time are not only possible but probable. And the DIT portfolio creation process is so simple that individual investors can implement and manage them on their own, without the help of an advisor.
This is the future of portfolio design and development and both individual investors and financial service providers will benefit greatly!