Question: In last week’s column, you said the endowment style of investing is appropriate for individual investors and that the Uniform Prudent Management of Institutional Funds Act (UPMIFA) introduced concepts of Modern Portfolio Theory, brought endowment investing into the 21st century, and freed endowments to invest for total return, which includes gains in principal along with interest and dividends. What is Modern Portfolio Theory?
Answer: During WWII, academics developed “Operations Research” techniques involving statistics and linear programming to hunt enemy submarines, supply troops on the ground and deliver ordnance to targets. Soon after the war ended, Operations Research academics began to apply their methodologies to investing.
In 1952 Harry Markowitz, a graduate student at the University of Chicago, published a paper on portfolio selection in the Journal of Finance. Markowitz’s quantitative approach to investment theory was radically different from the conventional stock market wisdom at the time, which focused on picking winning stocks and concentrating stock holdings to maximize return. Investors knew that holding stocks meant taking risks, and they were led to believe that the only way to reduce risk was to become more competent at picking stocks. Some investors were following the advice of Gerald M. Loeb, the co-founder of brokerage firm E.F. Hutton, who wrote “once you obtain competency, diversification is undesirable.”
Markowitz’s work along with others gave birth to what is now known as Modern Portfolio Theory (MPT). MPT provided investors quantitative ways to reduce risk and optimize their return. It was slow to take off, and over the years many bright academics and scholars made significant contributions to the theory, giving us the quantitative investment portfolio tools widely used today. Markowitz’s contribution was so important that he along with two other highly acclaimed contributors to MPT, William F. Sharpe and Merton Miller, were awarded the Nobel Prize in Economic Sciences in 1990 for their pioneering work in the theory of financial economics.
Investors using Modern Portfolio Theory’s quantitative techniques can theoretically choose a portfolio of investments that will give the greatest rate of return possible for a given level of risk, or the least risk for a given level of return. MPT is not perfect and is often criticized, but it’s far more prudent than simply trying to pick superior stocks or trying to time the market.
Like UPMIFA for endowments, the Uniform Prudent Investor’s Act (UPIA), which is part of the California Probate Code in Sections 16045-16054, incorporates Modern Portfolio Theory into the law. MPT gives trustees fiduciary investment guidance, which if followed provides protection from claims of mismanagement of funds. Section 16047 of the code says that “The trustee’s investment and management decisions must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an investment strategy having risk and return objectives reasonably suited to the trust.” That’s Modern Portfolio Theory in a nutshell.
UPIA’s guidance for trustees can be helpful to individual investors. The guidance suggests that you consider the following items when developing your portfolio: general economic conditions; inflation or deflation; expected tax consequences; the role that each investment or course of action plays within the overall portfolio; the expected total return from income and the appreciation of capital; needs for liquidity, regularity of income and preservation or appreciation of capital; and an asset’s special value, if any, to your objectives.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth Inc. in Monterey. Send questions concerning investing, taxes, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or email@example.com.