Addressing the Human-Risk Factor in Investing
In this article I discuss how a new approach to investing can dramatically reduce the risk inherent in basing portfolio design and management decisions on subjective human judgments.
In previous articles on this site I have explored ways to improve how investing works today by breaking out of the Modern Portfolio Theory (MPT) “box” and thinking differently about portfolio design and management. At the center of this discussion is a new approach to investing developed by my organization, the National Association of Online Investors (NAOI), called Dynamic Investment Theory (DIT). DIT creates a new investment type called Dynamic Investments (DIs) that our testing has shown are capable of providing significantly higher returns than MPT portfolios with lower risk.
A major reason why DIs perform so well is that they reduce what we call the “human-risk” element in the investing process. This is the type of risk inherent in portfolio design and management decisions based on subjective judgments made by investors and/or those who advise them. MPT has very limited tools for mitigating this massive area of risk. DIT virtually eliminates it. In this article I show how.
Before doing so, however, here’s a quick review of DI components and how they work. A more detailed description can be found on this site at this link.
Dynamic Investment (DI) Components:
- Dynamic ETF Pool (DEP) – This is an area of the DI where designers place ETFs that are candidates for purchase by the DI. Typically these ETFs track uncorrelated asset classes such as Stocks and Bonds. Only one of these ETFs is held by the DI at a time; this being the one that is trending up most strongly in price at a scheduled, periodic review as discussed next.
- Review Period – All DIs are reviewed on a periodic basis as defined by the designer; “quarterly” is an example. At a review event, the ETFs in the DEP are ranked by the Price Trend Indicator (see below) to identify the one having the strongest price uptrend. This is the one ETF that is purchased, or retained if already owned, and held until the next review event.
- Price Trend Indicator – This is the indicator used to rank the ETFs in the DEP to find the one with the strongest upward price trend. A simple Price Trend Indicator used by the NAOI in our DI designs is the percentage price gain of each ETF in the DEP for the previous quarter.
- Trailing Stop Loss Order – This is a broker order placed on the ETF bought, or held, at a review event that automatically sells the ETF should its price drop by a designer-specified percentage during the short time that it is held between review events. Typical sell triggers are 7% and 10%.
You can see the Dynamic Investments are a comprehensive investment type. They not only specify the ETFs to work with but also how they are to be managed on an ongoing basis.
How Dynamic Investments Mitigate the Human-Risk Element
Human-risk comes into play when portfolio actions are taken based on subjective human judgments. Below are the five steps of today’s MPT portfolio design and management process. For each step I first show the role played by human judgments in making decisions. I follow that with a description of how the human-risk element is reduced or eliminated using Dynamic Investments.
Step 1. Determining an Investor’s Risk Profile
MPT: Modern Portfolio Theory dictates that portfolios be designed to match the risk tolerance of each investor. Determining risk tolerance is heavily dependent on subjective judgments related to how investors “feel” about the potential of investing losses and it is difficult to answer questions of this nature with a high degree of accuracy. Yet this step dictates the asset allocations of the investor’s portfolio and thus how much money he or she can expect to accumulate over their investing career. Getting an investor’s risk-tolerance wrong can be a disaster. Thus, the human-risk element enters the investing process at the very beginning and in a huge way.
DIT: Dynamic Investments are designed to seek out and capture the gains potential of price uptrends that exist somewhere in the market at all times. Their goal is simply to maximize gains and minimize risk in all economic conditions. This is a universal goal that works for all investors regardless of their risk profile. Thus, DIs don’t require a risk-tolerance assessment and the risk of getting it wrong is eliminated.
2. Defining a Portfolio Asset Allocation
MPT: Modern Portfolio Theory shows how to match an investor’s risk tolerance with an optimal portfolio asset allocation. This is the ONLY step of the MPT-based portfolio design process that is based on objective observation of historical data as opposed to human judgments. But, if the risk tolerance isn’t accurate, the asset allocation won’t be accurate either.
DIT: DIs hold only one ETF at a time with a 100% allocation of investor money. No asset allocation decisions are needed. Thus the risk of owning or recommending a portfolio with a non-optimal asset allocation is eliminated.
3. Populating Each Asset Class with Specific Equities
MPT: With an asset allocation in place based on MPT methods, each asset class must be populated with specific equities. Typically this is done by an advisor who is also a salesperson and sales bias may come into play. Thus, in the MPT process for portfolio design there exists the risk of equity recommendations based on the fees paid to an advisor and not based on the best interests of the investor.
DIT: DIs are created with a predefined set of ETF purchase candidates, selected by the designer, in its Dynamic ETF Pool. When used as designed, DIs provide no opportunity for advisors / salespeople to recommend inferior equities or those with excessive fees. Thus the human-risk element related to sales bias or poor equity selections is eliminated.
4. Managing the Portfolio on an Ongoing Basis
MPT: MPT provides no guidance on how a portfolio is to be managed on an ongoing basis other than to buy and hold it for the long-term with perhaps a periodic rebalancing to restore the original allocation percentages. The decision of when to rebalance the portfolio is a critical subjective judgment that managers must make and bad decisions here can cause a portfolio to become dangerously vulnerable to market downturns as allocations drift from their original percentages.
DIT: The design of a DI specifies how often its DEP is to be reviewed to identify and buy, or retain if already held, the ETF with the strongest upward price trend. Thus, the massive risk related to deciding when to rebalance a portfolio and/or what trades to make in response to changing market conditions is eliminated.
5. Getting Out of a Falling Market
MPT: MPT embraces a buy and hold portfolio management strategy. Therefor it is not sensitive to market movements and its value can be decimated by a market crash. Simply holding a portfolio while the market is falling can result in significant losses that take years to recover from. Yet investors or advisors who decide to get out of a severely downtrending market run the risk of missing the early days of a market recovery when gains are the highest. Again, the risk of incorrect human judgments in this area of portfolio management can have disastrous consequences.
DIT: DIs are constantly monitoring market price trends based on a periodic review of the ETFs in their DEP and by doing so eliminate the need for guessing at how to deal with a downtrending market. For example, if the DI is holding a Stock ETF and its price goes down by a predetermined percentage, it will be automatically sold by a Trailing Stop Loss Order. No human judgments are needed to get out of the market. And getting back in is automatic as well. If the stock market is still downtrending at a regularly scheduled review event, the DI will buy a Bond ETF that should be moving up in price. If the stock market is recovering at the next review event, the Stock ETF will be repurchased and early recovery gains will not be missed. Thus, using DIs, the risk associated with bad decisions related to whether or not to get out of a downtrending market is dramatically reduced.
Objective vs. Subjective Based Decisions: The Difference Is Significant
From the above discussion you can see a major different between today’s MPT based approach to portfolio design / management and the NAOI’s new DIT approach. MPT takes portfolio actions based primarily on subjective human judgments that inject a major risk factor into the process. DIT takes actions based on objective observations of empirical data, eliminating the human-risk factor.
This difference is a major factor in enabling Dynamic Investments to produce higher performance than today’s MPT portfolios and with lower risk. In addition, NAOI students who are currently working with DIs have told us that holding this market-sensitive investment type is a lot less stressful than holding the static, buy-and-hold MPT portfolios that they have owned in the past.
It should be noted that individuals of all experience levels can implement and manage DIs by following very simple instructions provide by the NAOI and using an online broker. The process can also be easily automated.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.