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Acknowledgments: We extend our gratitude to Dr. Stephen Huxley and J. Brent Burns for their helpful comments during the writing process.
Harry Markowitz, whose name every financial planner knows, published two papers, one in 1952 and the other in 1991. The latter sought to correct misunderstandings that arose from the former. Together they provide a valuable, yet incomplete, architecture for guiding individual investment decisions.
The first paper, Portfolio Selection, is by far the most famous and considered the origin of “modern portfolio theory” (MPT). Though it was only 15 pages and included a lot of images, the paper was fairly easy to follow. He pointed out that the standard approach to investing at that time – that investors should seek the single stock with the highest expected return – was wrong because it failed to take into consideration the variance of the returns. He posited that investors viewed variance as an “undesirable thing” and any theory attempting to explain how to construct a portfolio should factor both return and variance into its calculations.
Markowitz used the word “investor” without specifying the investor. Large Wall Street brokerage houses picked up on the work in their eagerness to gain market share in the personal investing business. MPT offered academic prestige to a particular approach for investing that was easy to explain. It could be standardized to allow scale and it gave Wall Street brokers a script to follow.
MPT provided a coherent mechanism for top-down control over brokers through model portfolios.
During the 1970s, MPT blossomed into the reigning paradigm for personal, as well as institutional, investing, despite the fact that Markowitz never anticipated, nor advocated, for such an adaptation. Individuals seeking advice from different firms could be offered drastically different portfolio modeling solutions, all using MPT.
In 1991, Markowitz corrected the broad application of portfolio theory to individual investors when he re-asserted his views in “Individual vs. Institutional Investing.” This less familiar, eight-page article addressed the differences between institutional investors (Markowitz, 1952) and individual investors (Markowitz, 1991):
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…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.
Additionally, the article contrasted a simulation approach, linear and dynamic programming, to an approximation or framework approach, which better accommodates an individual’s unknown time horizon and uncertainty. Simulation methods have dominated most of the financial industry literature.
Seeking to highlight the individual investor and assist their advisors, Markowitz (1991) laid out a four-step process that could be implemented by the advisory industry that is anchored in framework analytics. Beginning in the first paragraph, he laid out a four-step process that could be implemented by the advisory industry for individual investors:
- Step 1 is deciding what goals are essential to the family planning process. To decide those goals, an a priori framework analytical approach should be embraced that is constructed around individuals.
- Step 2 is to formulate optimizable sub-problems. While there are optimization solutions, some for individuals, the subproblems are unique to individuals. For example, individuals have unique, unknowable risks: their personal longevity and the conditions (market, health, etc.) within their longevity that they will encounter.
- Step 3 is to use technology to interpret and record decisions. Advisors can use technology to track how planning goals, decisions, and the investing environment are aligning over time. Technology also allows scenario simulation, stress testing, and graphical modeling, which can help interpret an individual’s financial context relative to their goals.
- Step 4 is to use robust decision rules in the plan. A plan offers perspective at a fixed moment in time on the robustness of a set of possible financial decisions. A plan is also a dynamic process that must adapt as the contours of individual experiences stress test the original plan. Therefore, it is essential that the plan is adaptive to ever-changing fact patterns. Plan adaptation should be governed by rules for the individual, not the institution.
Since the great recession of 2008, some framework analytical approaches have been given greater consideration by some in financial services. An example of an individual investor framework approach is a liability-driven, dedicated portfolio.
What is clear from Markowitz’s two primary articles is that the current application of portfolio theory is inappropriate as the default position for investing for an individual’s portfolio. Regularly considering our default positions by examining competing viewpoints and comparing how applications are made among various options is critical to all human institutions. Advisors should re-think the application of MPT to individuals. Markowitz 1952 offered institutions valuable guidance in portfolio construction, but Markowitz 1991 pointed to better ways forward for individuals.
Jason K. Branning, CFP® and M. Ray Grubbs, Ph.D. are principals with MRT, LLC a retirement education firm based in Ridgeland, MS. Additionally, Jason is an investment advisory representative of Asset Dedication, LLC, an SEC registered investment advisor and Ray is a tenured professor at Millsaps College in Jackson, MS.
 In an interview, Markowitz said the name “Modern Portfolio Theory” was coined by Barr Rosenberg. Dr. Rosenberg went on to found one of the earliest quantitative investment analysis companies. Barr Rosenberg Associates (BARRA). In 2011, however, Dr. Rosenberg was barred from the investment industry for life by the SEC.
 Huxley, Stephen J., and Burns, Brent. Asset Dedication. McGraw Hill, 2005. Chapter 1.
 Markowitz, Harry. Individual versus Institutional Investing. Financial Services Review, 1(1):1-8. 1991.
 Bodie, Zvi; Kane, Alex; Marcus, Alan. Essentials of Investments, 8th ed. McGraw-Hill Irwin, 2010, p. 344.
 Branning, Jason, and Ray Grubbs. 2010. “Using a Hierarchy of Funds to Reach Client Goals.” Journal of Financial Planning’s Retirement Distribution Supplement (December). p. 31-33.
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