A simple heuristic model in conjunction with the basis of diversification and client subjectivity will produce portfolio structures that will perform at least as well as any solution MPT can provide. Consider the Life Cycle Hypothesis (LCH) of investments as such a heuristic model. For example, imagine that the decision is to use the LCH to save and fund a retirement plan. Under this heuristic, a new career individual would generally be aggressively invested (in small caps, emerging markets, high-yield bond funds, etc.) as they tend to grow their wealth over the longer run.
As these clients age, they would slowly move over to less aggressive investments such as large-cap stocks and begin buying into income/balanced funds or into fixed-income products. Finally, in their late careers they'd be mostly in fixed-income type conservative, income-producing securities (bonds of all types, fixed annuities, TIPS, etc.) with a small amount in equities (that taper off with time) left for a little growth over the retirement years. Using these guides, one might start putting together portfolios but incorporate other asset classes (beyond global equities and fixed income) into the portfolio mix.
For example, a 60-year-old working his last five years before retirement may have a current allocation of 60% fixed income and 40% equity. This allocation can be augmented in general with reallocations into real estate, commodities, currencies and cash. The benefits of diversification will follow automatically without the need to use any explicit model of diversification. To fine-tune the exact allocations, the individual client's subjectivity requires consideration.
A more conservative retiree may start with a 70% fixed income allocation and then switch to a mix of 65% in fixed income, 20% in equity and 15% in other asset classes. Further, the retiree's attitude to loss can be explicitly incorporated. For example, if a client answers that he cannot absorb a total portfolio loss of 10% in any given year, he would have a much more conservative portfolio structure than one who could live with a 15%-20% loss. Another important client-specific input leading to a better allocation would be the amount of accumulated savings that were already in the fund or the state of the family's health and longevity. Advanced planners ask many of these questions as part of their routine to make better allocation decisions.
If most clients of advisors had followed these simple guidelines, then the ravages of the previous financial crisis would have been considerably mitigated. Older investors would mostly be in fixed-income type, well-diversified portfolios. Younger people would buy and hold their positions and weather out the downturn and witness portfolio value rebounds. Instead, the fear of losing more after a crash (!) causes all sorts of reactions like selling out low and then buying into CDs and other expensive savings products with long-lasting destructive impact.
What is remarkable about this approach is that the need to structure portfolios based on historic means and standard deviations and their resulting problems becomes unnecessary. This should be considered a benefit. The main reason for this benefit is that the concept of LCH is firmly rooted in the concept of loss aversion. Moving from equity to bond holdings is nothing more than a reflection that problems from larger losses at old age that are much more difficult to fix are being avoided through this mechanism.
A critical examination of the results of the 2008 financial crisis and its fallout will surely reveal that clients today are more unified by fear of further significant losses than by a willingness to earn higher returns by buying riskier assets and securities. Advisors would be able to relate to this new state analogically through their own client experiences. This new environment is thus also engendering this new vision of personal money management as advisors struggle to understand the ground realities of loss aversion.
Loss aversion generally will lead to portfolio structures that are in general more conservative than those based on risk-return strategies. One of the effects of more advisors structuring loss-averse portfolios will be to bring down long-term portfolio expected returns to a more meaningful 6%-10%. It is worthwhile to note that an average annual return of 8% over 15 or more years will in general produce very satisfactory financial outcomes. A related macro-economic benefit is that if advisors are disciplined in this approach, then the effects of the series of bubbles and crashes in various financial markets would be considerably reduced. The discipline would reduce or prevent markets from reacting when investors run as a herd, chase returns or demonstrate some other troublesome group behavior.
Finally, for advanced planners, loss aversion may be managed by the use of derivatives. This approach is consistent with the loss-aversion approach in insurance. Just as we buy home or auto insurance to pass the risk of loss to the insurance company, we can structure portfolio investments to contain an investment element. Consider the following simple example: Let's assume that a portfolio is worth $1 million and is invested completely in a domestic large-cap equity index fund like the S&P 500. Also assume that the one-year premium on an at-the-money call option on the S&P 500 is 8% and the risk-free, one-year money market rate is 3%.
Instead of investing the entire $1 million in the index fund, invest 90% in the money market fund and the other 10% in the call option position. This is akin to insuring the portfolio for a year at a cost of about 5.3% (the 8% option premium minus the 3% earned on 90% of the money). The portfolio could not lose more than this amount. On the upside, this portfolio would have the same performance as the index fund minus the 5.3%. Thus, if the market moved 12% up in the year, the gain would be 6.7%. If the market moved down 12%, losses would still be fixed at 5.3%. The strategy would be rolled over every year.