Thursday, March 8, 2012

Harry Markowitz's "Individual versus Institutional Investing"

I am re-reading Moshe Milevsky's Are You a Stock or a Bond? (it is even better than Pensionize Your Nest Egg, but I read it so long ago that I forgot all of the great contents).

In it, he mentions Harry Markowitz's 1991 article called "Individual versus Institutional Investing" from the very first issue of Financial Services Review. If you are not familiar with this name, Markowitz won the Nobel Prize in Economics in 1990 for his work on developing Modern Portfolio Theory (MPT) in the 1950s. MPT was a brilliant insight compared to what people were doing before its development. He explained how investments should not be considered in isolation, but in how they contribute to the overall portfolio. A very volatile investment could help reduce portfolio volatility if its movements are in the opposite direction of the rest of the portfolio. Diversification! Fund managers seemingly hadn't realized that beforehand, as they thought one should just choose what they felt are the very best potential investments.

And fund managers were what Dr. Markowitz had in mind when developing MPT as this quotation from the 1991 article explains:

The “investing institution” which I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or “mutual fund... It was plausible to assume for the mutual fund that its objective is to obtain a “good” probability distribution of year-to-year (or quarter-to-quarter) percent increase in its net asset value.

As well, the first paragraph of this article explains:

Professor Mandell, editor of Financial Services Review, invited me to contribute an article related to financial research for the individual for the first issue of this journal. Since the subject is not my specialty, it was uncharacteristically risky of me to have accepted the invitation. But an evening of reflection convinced me that there were clear differences in the central features of investment for institutions and investment for individuals, that these differences suggest differences in desirable research methodology, and that a note on these differences may be of value.

The rest of the article then describes using a simulation framework to develop a game-of-life to determine what is most critical and important to model from a lifetime perspective for an individual household, and to develop decision rules to respond to the random events of life. A lot of research since then, from William Bengen's SAFEMAX and on down the line, has moved in precisely this direction.

This article appeared in 1991.  I only recently became fully aware that the CFP® designation for financial planners only teaches about MPT when it comes to investing. MPT teaches how to operate a mutual fund company. It doesn't teach how individual households should build investment strategies to meet their lifetime financial planning goals. The CFP® designation misses all of this and also misses out on covering the retirement distribution process as I discussed in "More on CFPs and RMAs" and "CFPs and RMAs"

What can be done about this?  I am now the curriculum director for the Retirement Management Analyst (RMA) designation, which covers an important part of financial planning: developing retirement income strategies.  Of course I hope the RMA designation can become quite useful and popular, but already the CFP® designation is very famous. I hope their curriculum can be improved as well.