The Evolution of the Modern Portfolio Manager

Modern Portfolio Theory (MPT) was initially created by Harry Markowitz and is, to many, the guide stick for portfolio construction.  Markowitz put parameters for evaluations and set out ideas for managing money supplies to control economic output.  In portfolio management, there is one concept that Markowitz made famous.  Risk and returns are tied together and correlated oppositely: in theory, the more risk, the more returns.  Harry earned a Nobel prize for his work, but not until decades later.  MPT has not changed much over the years, and Risk has been documented throughout history.  Risk is an old concept repeated like rhymes over the past millennium.  No two stories are the same, but all have a common theme.  The higher the risk, the higher the reward, but it carries a possible higher loss.  Early on, the most significant risk in human civilizations was how to survive.  Humanity has luckily evolved since this period, and so has our ability to take on more risk. 

Portfolio Theory today is not calculated by the success of living but by living a great retirement.  Living your best life depends on your retirement funds collected and grown over a lifetime.  These funds are not life and death, but some feel strongly enough about their money to cause extreme stress and anxiety.  Risk and Reward have changed over the last five centuries, and that will not hinder as humanity reaches for new heights.  The current market for retirement investing has also changed rapidly, and so has Portfolio Management.  Over the last 60 years, many great portfolio managers have dedicated their lives to the science of risk management—some familiar investor names like Warren Buffet, Benjamin Graham, and Ray Dalio have made significant contributions to the study of portfolio management.  Many portfolio pioneers like Markowitz have studied the markets and created successful long-term returns.  Buffet Uses Time, Fear, and Greed to get advantages in managing risk.  Ray Dalio uses correlation, allocation, and diversification.  Graham was the “father” of value investing and used fundamental analysis, contrarianism, and science to gain advantages.  Using this knowledge as a reference, a person can use this collective knowledge to make better portfolios that will last many lifetimes.  Buffet’s Fear and Greed teaches us when to buy, Graham’s scientific analysis guides what to buy, and Dalio’s allocations bring it all together.  AAM’s portfolio Theory works on these ideas and simplifies the process: we take the best ideas, test them in the market, and slowly adjust them to the ever-changing world.  Knowing what to buy seems like the most crucial part of portfolio management, but it is not.  The scientific work of Ibbotson and Kaplan proves that 80-100% of a portfolio’s returns are determined by asset allocation, not asset selection. Diversification is another essential part of portfolio theory, and passive index investing was made famous through Jack Bogle’s ETFs (Vanguard).  Putting all these concepts together is my contribution to the science and art of investing.

Our best portfolio managers today are no longer the high-flying, significant risk-takers.  The market is now dominated by index investing, and for a good reason.  ETF index investing has beaten the best portfolio managers annually for more than 30 years.  One manager may exceed the average one year but not the next.  Today a great manager is an acquirer of assets with a strong background in communication.  The best managers are now more writers than stock pickers, who act as fiduciaries learning the markets daily.  These changes are beneficial to the client, and the governing agencies are also pushing for change among professional portfolio managers. 

My own experience with being a portfolio manager is no different.  I have adjusted over the years by using liquidity, scarcity, and market premiums as my proposed advantages, similar to the great portfolio managers of our time.  I still strive to find all these ideas in the market but concentrate more on psychology.  My studies have changed to a focus where I am more interested in my relationship with the client than my portfolio management performance.  My role has slowly changed from picking the best option premiums and choosing the best stocks to eventually only picking the best ETF funds and communicating to the client to stay invested.  Education has also evolved over this period to match these fundamental changes to the standard advising approach.  I initially looked at the industry from the viewpoint of what credentials are needed to grow a business. Now I seek education to improve my understanding of each client’s psychology and well-being versus being consumed by past performances that have nothing to do with future returns. 

I still believe your investment choices are essential to a successful retirement but not as important as keeping the client invested through challenging markets.   Sometimes the selection of securities comes down to what the client is comfortable with, not what makes them the most returns.  I can spend another three pages explaining portfolio management and my selection of funds and allocations, but I will leave you with some thoughts instead.  Over time, investors learn from their mistakes and evolve not only as investors but as people.  I will never make a portfolio perfect, but I can create a great relationship with every client.  The most competent person still needs to be humbled by the market, the one thing they can’t control.  Here the only thing that matters is keeping the client calm, assured, and filled with resolve to get past inevitable downturns.  Finally, an investor’s experience is more valuable than education alone.

The evolution of the modern portfolio manager prioritizes the relationship between the client and adviser away from performance and more towards lifetime goals.  Financial planning first and asset management second are the essential change a portfolio manager needs to make.  The Advisers risk management changes to prioritize the allocation percentage rather than focusing on avoiding bad investments.  The last significant change to the adviser is their education; in the beginning, they focus on portfolio creation, and in the end, they focus on keeping clients invested and creating a lasting lifetime relationship.

I was recently turned onto a book from one of the best advisers in the game today, Josh Brown.  The book is “Against the Gods,” the remarkable story of risk by Peter L. Bernstein.  The book is one of my current favorites and gives a great history of risk-taking by humans and their ability to persevere.  I will leave with a quote from the book,” The story that I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decision on more subjective degrees of belief about the uncertain future.”  (Peter L. Bernstein 1996)

Gabriel Jones
Chief Investment Officer
AAM Fee Only Financial Planning and Investment Advisory LLC
July 13, 2022