Problems with Existing Portfolio Theory
The investment world was profoundly influenced by the invention of Modern Portfolio Theory (MPT) in the 1950s. The approach was to determine the best asset allocations based on static expectations of investment average returns, standard deviations and correlation coefficients. Typically, these expectations have been determined by assuming historical performance will persist: in essence trend following. This mean-variance model has remained the workhorse of Modern Portfolio Theory despite four concerns:
- The use of standard deviation as a measure of risk.
- The impact of non-symmetric return distributions.
- The large number of inputs that must be estimated (5,150 estimates for a 100-investment portfolio).
- The lack of a logical and justifiable procedure to generate the expectation inputs as time passes.
The DynaPorte Solution
A breakthrough in portfolio optimization, called DynaPorte, catapults Modern Portfolio Theory to a new level of usefulness by simultaneously eliminating all four MPT concerns at once.
- DynaPorte uses a downside risk measure in place of standard deviation.
- The downside risk measure effectively deals with non-symmetric return distributions.
- DynaPorte does not use the covarience matrix required by MPT. This dramatically reduces the number of inputs required.
- With DynaPorte, asset allocation levels are directly tied to influential factors that obtain the most profitable allocation mixes.
As a result, DynaPorte tells you when, why and how much to change your asset allocations based on fundamental relationships that you establish. DynaPorte gives you a navigation tool to confidently maneuver your portfolio holdings through time without becoming a trend follower.
Market Timing Versus Dynamic Asset Allocation
Market timing is a procedure for switching between 100% in stocks and 100% in cash when conditions warrant. There are only two investments involved. All assets are placed fully in one of the two investments. No partial allocations are allowed when employing market timing.
Dynamic asset allocation allows more than two investments in the portfolio. In addition, any combination of fractional allocations are allowed such as 35% stocks, 40% bonds and 25% T-bills.
Because market timing only used two investments, this limits the possible range of investment returns. By requiring 100% to be allocated to one investment at a time, market timing does not have as much control over risk as dynamic asset allocation has.