August 24, 2010
The portfolio pyramid
How should advisors and clients work together to build portfolios that incorporate utilitarian, expressive and emotional factors? Statman’s solution is to use a pyramid-based construction. The base of the pyramid should support a client’s core needs: to sustain a reasonable life style in retirement and meet other basic expenses. Those needs should be supported by a very low-risk portfolio, where risk is defined concretely as the probability of losing one’s money – not in abstract terms of standard deviation or volatility.
The next layers should reflect a client’s desire to pay for the educational needs of their children, and then other aspirational needs, such as the purchase of a second home or expensive vacations. Those portions of the portfolio should be supported with investments with successively higher levels of risk.
At the top of the pyramid are pieces of the portfolio to support bequests and donations, and to allow clients to “play the market,” Statman said. At these layers, clients should be able to afford to lose all their capital, and they can be supported with investments that reflect the highest level of risk.
A pyramid portfolio places losses, such as we have sustained recently, in perspective. If an investor lost 30 percent of his portfolio, what does it mean other than feeling like a loser? A pyramid portfolio answers the question. The bequest layer of the portfolio is decimated. A favorite charity would get no money unless the market recovers in time and the bequest to one’s children would be diminished. But the retirement layer is intact. There is money for food and shelter and for buying a new car when needed. The client is surely not happy about the loss but has a realistic and reassuring sense of the situation and how to plan for the future.
Mean-variance optimization can be used to construct a sub-portfolio to support each layer of the pyramid, Statman said. Indeed, each of the sub-portfolios and the amalgamated portfolio resides on the efficient frontier, but the assets in each sub-portfolio look very different from the assets in the amalgamated portfolio. And the amalgamated portfolio is different from a portfolio that is constructed without reference to the individual layers of the pyramid.
Statman told me that he once sent a note to Harry Markowitz, who was awarded the Nobel Prize for Economics in 1990 for applying mean-variance optimization to financial modeling, describing some of his research. Markowitz’ reply indicated that he agreed that investors typically think of their financial needs in terms of “mental accounts.” The two have since collaborated on research to redefine the appropriate role for mean-variance optimization in portfolios with layers or mental accounts..
An advisor once asked Statman how he should explain correlation and covariance to his clients. Statman said that teaching a basic course in statistics is not the primary role of an advisor. .Advisors should be focused on understanding clients' goals and helping them reach these goals. . Without sacrificing the utility of the mathematical tools, like optimization, that have been developed, “Investors need to move away from the perspective of meals prepared with a blender and not think about all their money as one lump sum,” he said.
When one experiences stomach pains, he or she often see a doctor to be certain that their illness is due to something they ate and not to something more serious. “Doctors give you peace of mind that you’re not about to die,” Statman said. Advisors should play an analogous role. Like physicians, who have specialized knowledge that their patients do not possess, advisors must apply their specialized skills to the unique needs of each of their clients.
“When you look at financial advisors and you choose one,” Statman said, “if the advisor tells you that his or her main service to you is to beat the market, I'd say go down the street to another financial advisor, because you want a financial advisor that is not just about your wealth but also about your well-being.” Avoid using an advisor who merely strives to beat the market, according to Statman, and instead choose one who considers the layers of one’s financial needs, and serves them as would a fine restaurant offering a carefully prepared meal.
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