MPT determines an investor's optimal asset allocation based on their risk profile and future cash needs. This article steps through how I determined my risk profile and future cash needs, and then used them to determine my asset allocation within my FI-investing strategy.
So, what is MPT again?
MPT is a Nobel Prize-winning investment theory pioneered by a bloke called Harry Markowitz in 1952 that today forms the basis of how most how professional investors put together their portfolios, including Hedge funds, Managed funds and Super funds. It states that since most investors are risk averse (i.e. don't want to lose money), they require more return for taking on more risk, that for each level of risk there is a corresponding combination of assets that maximises return, and that of all these portfolios, there is one that maximises the risk-return trade off - this is known as the Optimal Portfolio.
So, where on the efficient frontier is this optimal combination of assets?
To figure that out we first need to introduce the concept of the risk-free rate, or Rf, which is the rate that investors can borrow or lend money at. Theoretically, Rf allows us to lend money by buying risk-free assets with extra cash, or borrow money by loaning some extra cash to invest in the optimal portfolio.
Then, if we draw a line between Rf and the efficient frontier, the point on the efficient frontier that maximises the slope is the optimal portfolio (i.e. point B = Optimal Portfolio in the graph below).
Note that the gradient of the line between Rf and B is the Sharpe ratio and the line itself if called the Capital Market Line. This means is that the portfolio of assets at point B maximises the Sharpe ratio and the best return achievable in the Market for any level of risk is plotted along the Capital Market Line.
So, how we move along the Capital Market Line? Well, any of these points can be achieved by allocating a proportion of funds to the optimal portfolio and the rest to cash. We can even allocate a negative proportion to cash, i.e. we move along the line by lending or borrowing at Rf.
Theoretically, investors move along the line to their own "happy risk point" by lending or borrowing at the risk free rate to maximise the return they get for the amount of risk they're willing to bear.
Problem is, in practice, investors cannot borrow at the same rates they can lend. Investors can lend close to 'risk-free' by buying government bonds, however, we will always pay a higher borrowing rate than what we can lend at.
So, if our lending rate is different to our borrowing rate, then the capital market line becomes kinked, as shown below.
In this case, instead of having one optimal portfolio, there is a range of optimal portfolios between the two points of intersection of Rf and Rb. The higher the difference between Rf and Rb the greater the number of optimal portfolios and the more the benefit of leverage is reduced. Using current figures, AU Government bonds yields are around 1.5% pa, but most margin loans will cost you closer to 5% pa. So yes, it seems like an unfair trade, plus there's a bit of work involved in setting up margin accounts and monitoring asset values, so that's why for a long time I'd dismissed leveraged investing as a viable option for my own portfolio.
Ok, enough theory! How do I put it into practice?
Well, MPT is built around the concept of an optimal or market portfolio. In theory, this optimal market portfolio is a bundle of investments that includes every type of asset available in the world financial market, with each asset weighted in proportion to its total presence in the market (yes, the name kind of gives it away)! But how do we invest in every asset in the world in the right proportions?
But what if you haven't had to deal with a market crash yet? Or you think my past-experience approach sucks? Well, you're in luck. There are a bunch of Risk Profiling quizzes you can take like this FinaMetrica one. If you're a student it's free, you just need to sign up with your .edu email. The front page of my report is below. My results were what I expected. I imagine most FI-investors would be towards the upper end of this range.
Together, these two methods should give you a solid understanding of your investing psychology.
Next, we've got to consider our future needs for invested capital, both planned and unplanned. This is hyper-personal and I don't know of a broad way to give guidance here, but here are my circumstances:
I don't intend to access my current investment capital ever. This capital and a portion of my future capital is being used to become FI (financially independent), my #1 financial goal.
I haven't set other personal financial goals yet and apart from a lumpy income, my financial affairs and commitments are uncomplicated - not married, no dependents, etc.
When new goals do arise, I expect to be able to save for them in a way that doesn't compromise my FI-investing strategy.
In particular, when my life circumstances change and I want to purchase a house and other big-ticket items, I don't think my need for capital to purchase these items will ever be so urgent as to force me to sell at bad prices, if I need to sell at all.
I have private health insurance and always cover myself with travel insurance when abroad.
If absolutely everything goes wrong I have a family safety-net to fall back on.
The outcome of my personal circumstances is pretty simple. I intend to never need my invested capital that I put towards FI for anything other than achieving FI, and I am confident my circumstances will allow me to do this for the next 20 years.
But what if it wasn't so straightforward? Let's say that I plan on using this capital for a home deposit in 5 years time. How should I change my strategy?
Well, for me it would depend on how fixed I am on that 5-year timeline. If I would like to own a home, but not have to, then my strategy would remain very similar - I would just invest in the way that maximises my return over the long-term. If the sharemarket plugs along normally I'll be fine, and if it shits itself I will just wait until it rebounds. Of course, this all changes if I must buy a home in 5 years. In this case, and with a 5-year timeline, my capital really isn't safe in the market. Historical figures suggest I could lose up to 12% of capital invested over rolling 5-year periods, and 37% over rolling 1-year periods. So the decision now becomes a toss-up between how much I am willing to risk having to purchase a less expensive property vs the additional expected return. The difference is ~2% per annum in a HISA vs ~10% per annum in the market, or about 5x! Note that this isn't a static decision either, because as the timeline becomes shorter my risk of capital loss increases. It's a tough call that will be unique for everyone - far simpler to avoid getting into the position where I must do anything with my capital, I reckon.
So, taking stock of my situation: I've got no fixed future obligation for invested capital and I've withstood a ~75% temporary value decline before. This means for I can withstand a lot of volatility and so I am a fair way to the right on the horizontal axis below. As you can see, I'm past 'the kink' and so should theoretically have a leveraged portfolio with a mix of bonds and equities.
Up until recently though, I wasn't aware of any viable ways for retail investors to invest with leverage. The costs of margin loans (~5% pa + active monitoring) just didn't make sense, so my strategy to cost-effectively maximise my return had been to invest all my cash in AU & global equity ETFs and forgo bonds completely, as per the efficient frontier asset allocations below. ***
MPT and my investing strategy for FI
At Pearler, we pride ourselves on the quality of the financial advice we give. Please note though, that this advice has not been tailored for you. You have unique financial goals, circumstances and needs which may make this advice inappropriate, and it is important that you know whether it applies to you. If you are unsure we urge you to speak to someone you trust who is competent with money and understands your individual needs, whether they be a trusted friend or professional.