by Share the post "The Appropriate Portfolio vs the Optimal Portfolio" “Perfect is the enemy of the good” – Adapted Italian Proverb We all want the perfect portfolio, the portfolio that achieves the highest amount of return for the lowest degree of risk. But one of the inconveniences of a system as dynamic as a financial market is that it’s impossible to consistently maintain the perfect portfolio. This pursuit, unfortunately, causes more damage than good since it leads to increased activity, higher fees, higher taxes and usually lower returns. I have argued in my new paper, Understanding Modern Portfolio Construction, that this pursuit of alpha is misguided and that we should seek the appropriate portfolio as opposed to the optimal portfolio. Here’s my basic thinking: There is an abundance of data supporting the fact that more active investors do not consistently generate alpha or excess return.¹ Alpha is elusive because it doesn’t exist in the aggregate and because we all generate the after tax and fee return of the aggregate financial markets. So, the diversified low fee indexer must ask themselves – if I want to be properly diversified and alpha is impossible to achieve in the aggregate then is this a pursuit I should bother engaging in? For most people, the answer should be no. For most people, the generation of “alpha” is not a necessary financial goal.
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“Perfect is the enemy of the good” – Adapted Italian Proverb
We all want the perfect portfolio, the portfolio that achieves the highest amount of return for the lowest degree of risk. But one of the inconveniences of a system as dynamic as a financial market is that it’s impossible to consistently maintain the perfect portfolio. This pursuit, unfortunately, causes more damage than good since it leads to increased activity, higher fees, higher taxes and usually lower returns. I have argued in my new paper, Understanding Modern Portfolio Construction, that this pursuit of alpha is misguided and that we should seek the appropriate portfolio as opposed to the optimal portfolio. Here’s my basic thinking:
- There is an abundance of data supporting the fact that more active investors do not consistently generate alpha or excess return.¹
- Alpha is elusive because it doesn’t exist in the aggregate and because we all generate the after tax and fee return of the aggregate financial markets. So, the diversified low fee indexer must ask themselves – if I want to be properly diversified and alpha is impossible to achieve in the aggregate then is this a pursuit I should bother engaging in? For most people, the answer should be no.
- For most people, the generation of “alpha” is not a necessary financial goal. Asset allocators should be concerned with generating the appropriate return as opposed to the optimal return. This means building a portfolio that is consistent with your risk profile and managing it across time so that you maintain that profile while maintaining an appropriately low fee, tax efficient and diversified approach.
- The pursuit of alpha generation not only reduces returns by increasing taxes and fees, but also misaligns the way the portfolio manager perceives risk with the way the client sees risk. Since the portfolio manager is benchmarked to a passive portfolio they likely cannot outperform they will often exacerbate many of the frictions that degrade portfolio returns all the while increasing the risk that the client will not achieve their financial goals.
Of course, the “optimal” portfolio might not seem so different from the “appropriate” portfolio, but I would argue that there’s a substantive difference. For instance, let’s look at an example of a 40 year old man with $500,000 to allocate. Let’s assume he uses the simple “age in bonds” approach and comes to a 60/40 stock/bond portfolio. Every year this asset allocator should rebalance his portfolio so that he owns approximately 1% more in bonds. In all likelihood, the stock piece of the portfolio will outperform the bonds over long periods of time so he will consistently be tilting further away from stocks and into bonds. But why does he rebalance? He rebalances to maintain an appropriate risk profile, not to optimize returns and generate alpha. He is accepting the high probability of a good return and foregoing the risks associated with pursuing the perfect portfolio. This should be the approach taken by most asset allocators seeking to build a proper savings portfolio.
Countercyclical Indexing takes this process of risk profile based rebalancing a step further.¹ Since a 60/40 portfolio derives 85%+ of its risk from the equity market piece (and even more late in a market cycle) it is prudent to try to achieve some degree of risk parity across the market cycle. But we should be clear about the process of this rebalancing – we are not rebalancing to achieve alpha. We are rebalancing to better balance our exposure to asset risk across time. Said differently, we don’t implement this rebalancing to capture the best portfolio, but to capture an appropriate portfolio. In doing so, we are accepting that our portfolio might merely be “good”, but by pursuing the appropriate portfolio we are avoiding many of the pitfalls involved in pursuing the perfect portfolio.
If more asset allocators abandoned the false pursuit of the optimal portfolio I suspect they would perform better. Instead, they’ve let perfect become the enemy of the good.
¹ – See the annual SPIVA reports.
² See, What is Countercyclical Indexing?
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