Modern Portfolio Theory: The Risks — Part 1 of 3

How online investment advice companies and Modern Portfolio Theory are putting retirement savers at risk.

Did you know there are 37 new online advice firms promising retirement savers low fees? Yes, 37!

modern portfolio theory debunked

Modern Portfolio Theory relies on passive investing.

Most of these companies use proprietary computer algorithms to choose investments for you, based on Modern Portfolio Theory. They each have their own algorithm, however they have one thing in common — They are passive investors.

The good news is these start-ups do charge less than traditional financial advisors and planners.

The bad news is their computer models look backward with a passive investing approach. Passive investing does not address current economic and market conditions. A historical view presents great risk to retirement savers because past conditions may or not repeat and future conditions may occur that have never happened before, as in 2008.

Many online advice firms use computer algorithms to select their client’s investments in passively managed funds (such as Index Funds). This means they don’t benefit from an active portfolio manager’s adjustments in real time. Active managers can quickly assess and change portfolio holdings and allocations based on experience and what they see happening in the marketplace right now.

Enter Modern Portfolio Theory

Most people don’t realize that Modern Portfolio Theory failed retirement savers in the 2008 economic crisis. Americans lost over $2 trillion in retirement savings during this time, according to the Washington Post. Unprecedented market conditions caused the crisis that computer models did not (and could not) anticipate.

Modern Portfolio Theory asserts that investors allocate to a wide range of investments, even if they may not meet their needs or could cause a lower return.

You May Not See Modern Portfolio Theory at Work, But It’s There

Investors need to know that computer models are generally based on Modern Portfolio Theory. Passive managers rely on it to ease their burden of researching and investing in the best investments. It’s a double blow to use passive investing based on Modern Portfolio Theory to ease the responsibility of your financial advisor.

It is important to know this as you review the fine print of your financial advisor agreement. Most agreements state that you are responsible for understanding how the computer model works and underscores that you have chosen to use it. Therefore, investment advisors place all liability on the individual investor. As a responsible investor, you need to know the dangers of what you are passively agreeing to.

What’s an Investor to Do?

Use a tested and true alternative to failed computer models. Select active managers who monitor nuances of unprecedented economic conditions and who can and have proven they can adjust to real-time market conditions with measurable results for decades.

The second part of this series uses a current example of the dangers posed to your retirement savings by following computer algorithms and paying unnecessary fees.

 

Photo courtesy of deviantart.com

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