The inception of modern portfolio theory (MPT) in the 1950s by Nobel Prize-winning economist Harry Markowitz revolutionized investment management. It created a mathematical framework for assembling an investment portfolio designed to maximize returns at a given level of risk. In the decades that followed, this risk-based asset allocation approach largely governed how investors’ portfolios would be built—and with good reason. However, time would eventually expose two key practical shortcomings to Markowitz’s theory and its effect on the portfolios of individual investors.
The first disconnect between academic theory and investor reality occurs between the relative perspective each attaches to investments. MPT argues that a single portfolio can accommodate multiple goals, even though each may have different time horizons and risk tolerance levels. Of course, that’s mathematically possible to do, but it ignores the human inclination to separate savings into different accounts based upon the goal for those savings (often referred to as “mental accounting”). At first glance, this may not appear to be a meaningful distinction, but by collapsing multiple savings buckets into a single portfolio, it may create conditions that can lead to suboptimal investing decisions and returns.
Perhaps of greater consequence is how MPT defines “risk.” Under MPT, risk is measured by the standard deviation of an asset’s historical periodic returns, i.e., the degree to which actual returns deviate from their average. This is not how investors view risk. Individuals define risk in more practical terms; that is, the failure to attain one or more important financial goals. To address the shortcomings of risk-based asset allocation, there has emerged a new approach that places the individual’s goals front and center in building an investment strategy. It’s called goals-based investing (GBI).
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