Modern Portfolio Theory: The Risks of Computer Models — Part 2 of 3

A case study shows how online investment advice companies and Modern Portfolio Theory are putting retirement savers at risk.

In our first post, we introduced you to the risks of investing with online financial advisors that use proprietary computer algorithms that rely on a passive investing philosophy and Modern Portfolio Theory.

In this post, we’ll look at an example from Betterment.com to illustrate the risks.

Why now?

The Federal Reserve’s action to ease interest rates in an effort to improve the economy has put us in an unprecedented economic environment. The action is buying $85 billion in bonds each month, putting more cash into the economy so there’s more to loan, more to circulate, more to spend.

The result of this action is that interest rates are historically low, which means the interest earned by investors is also historically low. Not a great time to have your cash tied up in fixed-income securities that could significantly lose value.

As you may recall, earlier this year, Not On My Nickel highlighted that the SEC and FINRA both warned investors about the dangers of excessive risk in the bond market. Invest in long-term bonds today and you’ll miss out when interest rates go up because your bond will be worth less when it comes time to sell it. We urged you to take a wait-and-see approach toward investing in bonds with maturities greater than three years so you’d be ready to move into longer-term bonds when interest rates increase to improve your return.

Use this link to the Financial Industry Regulatory Association’s (FINRA) site about the risks of bonds due to this unprecedented economic scenario to learn more.

Betterment.com’s use of Modern Portfolio Theory

Betterment does a good job of educating investors, however, they are blindly following Modern Portfolio Theory and strictly using passive investments, often in the form of ETFs (Exchange Traded Funds).

Yahoo Finance’s chart below represents Betterment’s advice, based on their computer model, which is in turn based on Modern Portfolio Theory. They use passive funds to implement their investment strategies.

Betterment advised their clients to place 50% of their cash allocation into a passively managed ETF, the iShares Barclays TIPS (the green TIP line in the chart).  We are not certain if their “cash allocation” is meant for long-term or short-term purposes or if it is just the “cash” allocation based on Modern Portfolio Theory.

50% in a longer-term government investment (TIPS) (this ETF represents about eight years duration) is a lot to risk in this unprecedented economic scenario. As the chart shows, Betterment’s investors would have lost close to 8% from May 13to June 24, alone.

modern portfolio theory debunked

Modern Portfolio Theory, combined with passive investing, is risky

If their clients had adjusted their allocations based on the SEC and Federal Reserve’s warnings (not Betterment’s advice based on historical interest rate environments) and stayed in short-term bond funds or short-term Treasury securities, these losses could have been avoided. A shorter-term bond fund recommended by the SEC and Federal Reserve, such as the blue AGG line in the chart above would have been a safer investment.   The safest would be to invest directly in an FDIC –insured CD, where your principal is not at risk, like in a bond.

Sure there are still losses (remember, it’s not the best time to be invested in bonds in this unprecedented economy), however they are significantly less that the passively managed ETF a computer model generated based on Modern Portfolio Theory, that advises strategies based on historical market conditions.

What Modern Portfolio Theory Advocates Would Say

The counter argument is that “over a 30-year period” these “blips in the market” will “average out.”

This prompts two thoughts to share with you:

  • First, do you have 30 years until you will need to rely on your retirement savings to ride out the current situation or are you going to start drawing from your retirement assets before 2043?
  • Second, even if you do not need to draw from these assets until after 2043, why do you want to take lower returns now – and have to work longer – when the SEC and Federal Reserve both warned investors about the dangers of excessive risk in the bond markets?
  • See for yourself: Look up your current employer’s retirement plan on BrightScope.com to see how much longer you may need to work to make up for the shortcomings of the plan. If you thought you were going to retire in 2043, you may need to think again.

What’s an Investor to Do?

You’ve already taken the first step by reading this blog and learning about your options. Let’s keep going because you should also know:

  • Many online sites, like Betterment, use “paid articles” to advertise, such as this one, “Betterment Review:  Asset Allocation Made Simple.” Paid advertisers have their own interests in mind, not the investor’s.
  • Learn about safer alternatives to invest your cash. Terms like “FDIC-Insured Money Market Sweet Accounts” and “FDIC-Insured Certificates of Deposits” just aren’t household names like mutual funds or ETFs. But they are better short-term investments for your cash as you wait out the inevitable return of high interest rates. If you want to strictly hold cash, place it in an FDIC CD (Certificate of Deposit) at a bank for nine months or less. This allows you a small guaranteed return on your cash as we wait to see how interests rates move during this time.
  • Learn about the unbiased, fully researched options provided by Not On My Nickel that always put investors’ interests first. A good example is an actively managed Balanced Fund that lets an experienced portfolio manager handle your “cash and bond allocation.”

We’ll discuss the benefits of active management in our next post

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