Thursday, March 8, 2012

Harry Markowitz's "Individual versus Institutional Investing"

I am re-reading Moshe Milevsky's Are You a Stock or a Bond? (it is even better than Pensionize Your Nest Egg, but I read it so long ago that I forgot all of the great contents).

In it, he mentions Harry Markowitz's 1991 article called "Individual versus Institutional Investing" from the very first issue of Financial Services Review. If you are not familiar with this name, Markowitz won the Nobel Prize in Economics in 1990 for his work on developing Modern Portfolio Theory (MPT) in the 1950s. MPT was a brilliant insight compared to what people were doing before its development. He explained how investments should not be considered in isolation, but in how they contribute to the overall portfolio. A very volatile investment could help reduce portfolio volatility if its movements are in the opposite direction of the rest of the portfolio. Diversification! Fund managers seemingly hadn't realized that beforehand, as they thought one should just choose what they felt are the very best potential investments.

And fund managers were what Dr. Markowitz had in mind when developing MPT as this quotation from the 1991 article explains:

The “investing institution” which I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or “mutual fund... It was plausible to assume for the mutual fund that its objective is to obtain a “good” probability distribution of year-to-year (or quarter-to-quarter) percent increase in its net asset value.

As well, the first paragraph of this article explains:

Professor Mandell, editor of Financial Services Review, invited me to contribute an article related to financial research for the individual for the first issue of this journal. Since the subject is not my specialty, it was uncharacteristically risky of me to have accepted the invitation. But an evening of reflection convinced me that there were clear differences in the central features of investment for institutions and investment for individuals, that these differences suggest differences in desirable research methodology, and that a note on these differences may be of value.

The rest of the article then describes using a simulation framework to develop a game-of-life to determine what is most critical and important to model from a lifetime perspective for an individual household, and to develop decision rules to respond to the random events of life. A lot of research since then, from William Bengen's SAFEMAX and on down the line, has moved in precisely this direction.

This article appeared in 1991.  I only recently became fully aware that the CFP® designation for financial planners only teaches about MPT when it comes to investing. MPT teaches how to operate a mutual fund company. It doesn't teach how individual households should build investment strategies to meet their lifetime financial planning goals. The CFP® designation misses all of this and also misses out on covering the retirement distribution process as I discussed in "More on CFPs and RMAs" and "CFPs and RMAs"

What can be done about this?  I am now the curriculum director for the Retirement Management Analyst (RMA) designation, which covers an important part of financial planning: developing retirement income strategies.  Of course I hope the RMA designation can become quite useful and popular, but already the CFP® designation is very famous. I hope their curriculum can be improved as well.


  1. Wade --

    In the early 1990s, a little company named Frontier Analytics introduced the first PC application of Harry Markowitz’ modern portfolio theory (MPT). A software product named AllocationMaster, it led investment advisors to take the client through a two-step process:

    STEP 1. Mislead the client to choose a mix of asset classes for a long-term dollar plan and goals based on comparison of the mixes in percent return rate for the individual year, omitting the dollars and years of her plan and goals and effects of compounding along the way. In that comparison, she could not see which mixes were best or worst for her goals, nor see the terrible long-term effect of high financial industry fees. In that single-year percent-return-rate view, those effects were HIDDEN.

    STEP 2. Mislead the client to DE-diversify by SWITCHING from investment in those blindly selected asset classes to any of thousands of gambles WITHIN the asset classes such as actively managed funds with higher fees. This was achieved by presenting the stunning notion that any gamble WITHIN an asset class is equivalent to an investment in the whole diversified asset class.

    That two-step process has been given several names. One of the kinder is HIDE AND SWITCH.

    For obvious reasons, the financial industry loved this scheme. But what advisor would buy it?

    Heh heh. On that little company’s website, Harry Markowitz appeared with his Nobel Prize, recently received for his origination of the MPT theory on which the AllocationMaster HIDE AND SWITCH was based. There on that website, he assured advisors that he checked the AllocationMaster assumptions. AllocationMaster sales took off.

    For two decades now, the Markowitz-endorsed AllocationMaster has been used by tens of thousands of investment advisors “guiding” millions of investors through that two-step process of MPT-based HIDE AND SWITCH. AllocationMaster is now sold by the giant SunGard firm, which currently claims on the Web that AllocationMaster is still used by 20,000 advisors “guiding” millions of investors.

    Soon after Markowitz’ first endorsement of AllocationMaster, other similar products for MPT-based HIDE AND SWITCH appeared on the market, from sources such as the firm of Yale professor Ibbotson. The College of Financial Planning used AllocationMaster to train future CFPs in its MPT-based process of HIDE AND SWITCH. Over the last decade, Fiduciary360 has built a business selling training and software for the same MPT-based process of HIDE AND SWITCH and awarding “fiduciary” credentials to advisors who take the training and use the software.

    In my records, remembrances, and views of the last 1½ decades of the financial planning and investment advisor profession, the names cited here are not names of honor.

    Dick Purcell

  2. Thank you for sharing Dick. I didn't know about this history. I don't really mean to turn this into a discussion of whether Harry Markowitz followed his own advice or not, but I just wished to emphasize that even the creator of Modern Portfolio Theory has suggested there is more to consider when dealing with individual financial planning. I know you've been saying this for years too, and your Portfolio Pathfinder software does a very good job in this regard. It builds the kinds of game-of-life simulations outlined in this 1991 article.

    Thank you.