One of the few commonalities among the thousands of VCs and angel investors is the consensus that the process of identifying an attractive private venture investment is “part art, part science”. The art part speaks to the inherent absence of certainty with respect to any venture’s viability. There are no absolute truths…no bankable checklist to follow that ensures a successful outcome for a private venture investor.

The science part? That’s simply hindsight, which of course is an exact science. Of the ways that I have derived knowledge as a private venture investor, hindsight is the most expensive, the least merciful and the most valuable.

When it comes to separating the wheat from the chaff, my primary screen is simple. For a private venture investment (PVI) to be worthy of the costly, time-consuming, bandwidth-bogarting process of evaluation, consideration, due diligence and deal term negotiation, it must initially meet these four criteria;

1.  There is a large market for the firm’s products or services

The size of the market must be material for a PVI to potentially achieve a high cash flow or high-multiple (positive asymmetric) outcome. The success of category-killer app, product or service in a small market lacks the potential of an exponential payoff and does not proportionately offset the risk of a loss.

Ideally, the market should not be merely mature—it should be a growing market. The market can be newly-emerging (alternative energy, for example) or non-existent (Twitter) at the point of the venture’s introduction of its product or service, but it’s potential must be measurable and meaningful.

The values set forth in the modern business classic Blue Ocean Strategy often come to mind. Blue oceans denote industries untainted by competition. In blue oceans, demand is created rather than fought over…competition is irrelevant because the rules of the game are waiting to be set.

I am predisposed to the notion that the initially contemplated product, service or business model rarely succeeds, and consequently ventures are frequently forced to adapt to new data points. This requires the room to maneuver that a large market provides.

2.  The firm has a sustainable competitive advantage

The venture must have a sustainable edge to attract and retain its market share. The location or lease of a real estate development can be an edge. The celebrity chef to a restaurant, the IP portfolio of a technology or medical device company or a strong distribution channel relationship can be a critical edge to a consumer product.

The more tangible, unique, defensible and proprietary the edge (such as patents)…the better. The competitive advantage should discourage competition and create a barrier to entry. The edge will vary according to the venture’s industry. First-mover status is often meaningless (like many others I prefer second-mover) and certainly not sustainable in a market of compelling size.

A sustainable edge to compete in a large market is critical to potential acquirers or public markets and the objective of realizing compelling multiples on an exit.

3.  The management team has compelling expertise in the contemplated market

You must have a great execution team. Visionary founders may be inspiring but they alone cannot bring a great idea home. Get an experienced and accomplished operator in early.

In a couple of my early investments I failed to hone this rule to its proper endpoint. Naively, I believed that the serial entrepreneur with prior liquidity events was a proven winner and worthy of the wager. The first time that formula fell short I failed to make the proper connection, the second time I learned the lesson. There will not be a third time.

Successful entrepreneurs too often become deal junkies fueled by the fumes of their prior triumph. Some become self-anointed business “generalist” experts (contradictory, eh?) that no longer feel restricted by the limitations of their actual core competencies.

The founding partners and management team must include an accomplished C-level executive or highly accomplished operator with a track record of proven experience with the specific business model and target market. Moreover, the operator must have the authority and discretion to execute the business plan. Serial entrepreneurial ego in the absence of domain expertise is a formula for failure.

4.  The deal terms are no less than fair, and ideally—favorable

Valuation, investor rights, board representation, management discretion and transparency with respect to material events, protective provisions, anti-dilution protection, liquidation preferences and optionality issues must incentivize and respect the source of the capital. The investor’s capital is the great enabler… the sine qua non for any venture.

Few things are as humbling as the successful venture that does not translate into a successful investment. I respect the often repeated axiom that a fair deal is one where both parties feel that they got a bad deal, but the end game should always be to negotiate favorable deal terms.

The probability of an attractive outcome is diminished if a private venture investment cannot meet these initial thresholds. In VC-speak you are nursing a newborn “zombie”…a walking dead venture…the ship is already sinking and it has not even left the port.

Album:   We Were Dead Before the Ship Even Sank, Modest Mouse, 2007

As my career has been largely devoted to the intersection of money management and venture finance, I am no stranger to the independent RIA universe.

I have worked with dozens of wealth managers and family offices that regularly evaluate and allocate to private venture investments. Although they represent a fraction of the RIA universe, they are invariably among the most successful of their peers. These progressive wealth managers represent the primary audience of this blog.

I regularly advocate that RIAs that possess the requisite mandate, the means and the mindset should embrace private venture investments–for the benefit of their client’s portfolios, as well as, their practices. Yet, the majority of independent wealth managers should best leave this sandbox to VCs and angel investors.

Does your advisory practice possess the rationale and the resources to advise clients in start-up, early-stage and other private venture investments?

Your advisory practice may be uniquely qualified, if you consider:

• (To begin by stating the obvious…) You are in the business of wealth preservation and wealth creation.  Without question, the primary source of family wealth in America is the result of private enterprise and private venture investments characterized by their potential for positive asymmetric outcomes.

• You embrace Modern Portfolio Theory.  Despite its flaws, MPT advocates diversification into non-correlated asset classes. One-off investments in private ventures are distinctly non-correlated to broader asset classes and major market indices and have exhibited less correlation during negative black swan events.

• You possess the proper due diligence skills.  In addition to those skills you also posess the doubting disposition that is critical in evaluating private investments. The skills that advisors have developed in the course of investment manager evaluation are relevant and applicable to the private equity universe. Moreover, your experiences have taught you to be cynical and skeptical of assumptions regarding future performance.

• You are an entrepreneur.  As an independent wealth manager have chosen to compete in a highly-competitive, low margin industry. Your personal experiences should render you more prone to recognize the prerequisite personality traits of a successful entrepreneur…de rigueur in the executive team due dilly process. You also recognize the mission-critical elements beyond the strengths of the management team that determine the probability of successful enterprise.

• You understand finance.  As a stock, sector and industry analyst you know your way around balance sheets, cash flow, valuation issues and income statements. I am frequently surprised at the number of professional private venture investors that have little understanding of business and finance.

• You possess both an awareness of regulatory issues and a fiduciary responsibility that is consistent with the best practices of seasoned angel investors and VCs.

• You are networked. Beyond your practice, you have access to an expansive network of tools, resources and expertise that are essential to evaluating new technologies, industry sectors, new business models, intellectual property and other elements of private investment. Your industry colleagues offer incomparable access to the analysts, research, legal and domain expertise that is required in the course of successful private investing.

• You have access to the critical resources.  As an independent wealth manager you have enviable access to the two most important resources of private investment….investor capital and deal flow. Your HNW clients most likely became HNW clients as a result of their own ventures in private investment. Serial entrepreneurs and HNW investors are an excellent ongoing source of deal flow.

Advisors that affirmatively identify which each of these traits may have the mandate and the means to expose their client’s portfolios to the asset class that has historically created the vast majority of our nation’s private wealth and can dramatically differentiate your practice from its peers.

More advisors should explore asset allocation beyond the lame limitations of highly-correlated asset classes, stale style boxes and pointless pie charts.

Album:    Playing the Angel, Depeche Mode, 2005

Private investments in venture and early-stage companies are characterized by their potential for positive asymmetrical outcomes (PAO). The risk of losing the entire investment is offset against the potential for high-multiple ROIs. But asymmetric outcomes refers to more than the non-linear relationship between risk and return…it also refers to the appeal of investments where multiple liquidity and exit outcomes are possible.

This is often referred to as optionality…current knowledge of the potential for multiple future outcomes.

According to his book, In an Uncertain World, Robert Rubin, the nine-figure alumni chairman of Citi, is said to have developed his appreciation of optionality in his prior days of risk arbitrage at Goldman. While practicing risk arbitrage, Rubin developed a penchant for optionality (keeping ones options open) and avoidance of a mindset that restricted decision-making to binary and zero-sum outcomes.

It is believed that Larry Summers ultimately coined the phrase “preserving optionality” back when he was deputy secretary of the treasury under Robert Rubin in the Clinton administration. It was meant to describe a strategy of keeping options open and fluid, before all of the uncertainties have been resolved in dynamic environments where there is a high likelihood for the emergence of new and material information.

The phrase is relevant in venture circles for investors, as well as, entrepreneurs.

Preserving Optionality for Investors and Entrepreneurs

For entrepreneurs, optionality in rapidly evolving scenarios (such as a start-up) means leveraging real-time data and experience before making important decisions that are either resource intensive or cannot be easily reverse…such as pursuing a market vertical, developing a new technology or application, embarking on a joint venture or contemplating multiple exit strategies.

In most instances these options were not conceivable at the outset of the venture because, at best, a start-up’s business plan is to an entrepreneur what a treatment is to a script writer…it’s simply a first draft. It is the actual, real-time development of the story line and its characters that ultimately determines the final draft of a movie script…or the path to monetization for a new business venture.

Investors and experienced entrepreneurs know this. I have rarely seen a startup that successfully monetized itself based upon the mission, objectives and milestones envisioned in its original business plan. That’s because time in the market is often more valuable than time to market with respect to improving the quality of the critical decisions that are of material consequence.

Technology consultant Sean Hull of the Heavyweight Internet Group notes this nuance…“preserving optionality is a philosophy that takes some getting used to. It involves having a sense of humor, and realizing our own human limitations.”

Author-epistemologist-investor Nassim Taleb gets it as well. In Fooled by Randomness he characteristically opines “people overestimate their knowledge and underestimate the probability of their being wrong“. He suggests that by being ever aware of our limitations of prescience, and keeping our eyes and our options open, we can make better, more educated, and lower risk decisions. He is correct.

This implications and realities of preserving optionality, often positions entrepreneurs at odds with investors. The interests of optionality must be balanced.

For the entrepreneur, preserving optionality is an interest that frequently requires a balancing act against intrusive, non-strategic, no-value-add investors who view accountability and measurability as metrics preeminent to the benefits of prudent executive flexibility and strategic discretion.

On the other hand, the investor’s needs for optionality is particularly relevant today in light of the macro market malaise and minimal marquis exits. With venture-backed IPOs now more an exception, venture investors need to stipulate optionality with respect to cash-flow and exit rights as a contingency to their investment commitment.

Investors need to see visibility to alternative liquidity events such as dividend distributions or return of initial capital beyond the sale or merger of the company or its assets, or a less than likely IPO.

It is of no surprise that investors have a preference for positively-skewed outcomes and hold an aversion to negatively-skewed outcomes despite the fact that linear or variance-based risk measures generally weigh the outcomes equally.

Yet, investors seeking the potential for multiple and positive asymmetric outcomes on their commitments must also apply the measures of asymmetry and optionality to their deal diligence and terms. More than ever, investors should require visibility on multiple paths to liquidity. The investor has the responsibility to appropriately balance their interest in ROI with the survival or expansion cash-flow needs of the portfolio company.

Why so many “professional” investors are so passive on this issue is puzzling.

Investors and entrepreneurs alike both benefit from preserving optionality and having the pre-negotiated discretion to pursue a prudent Plan B.

We will discuss those some of those options in upcoming posts.

Album:   Balance & Options, DJ Quik, 2000

Our recent proclamations that “MPT failed” have elicited a distinctively binary response from wealth managers and investment advisors. I have both the commendatory and the castigating emails and comment board posts that prove it.

While many IAs responded enthusiastically, a seemingly larger pool of advisors continue to cling desperately to their discredited diversification dogmas hoping that investors may not have noticed the failure of their advisor’s mantras and models even as last week’s front page WSJ article (“Failure of Fail-Safe Strategy Sends Investors Scrambling”) cited more examples of prominent institutions who who likewise believe that prevailing “asset-allocation strategies are fundamentally flawed”.

Last month in this column I introduced Hybrid Portfolio Theory (HPT) as an alternative to Modern Portfolio Theory. HPT is comprised of two distinct (hybrid) sub-portfolios; the larger (say, 75%) with the primary objectives of insuring safety of principal, liquidity and income by way of allocations to money markets, CDs, municipal and government bonds, while the smaller (25%) portfolio is opportunistically allocated to make investments that have a positive asymmetric outcome (PAO) profile.

In a recent Investment Advisor Magazine-sponsored webinar I defined PAO opportunities as those characterized by positively-skewed risk/reward ratios that can be achieved via investments such as venture capital, private equity, direct (angel) private investment in start-ups and emerging private and operating cash-flow businesses, private real estate, private debt, franchises, as well as, publicly-traded emerging growth companies, (long volatility) option strategies and other highly-specialized investment strategies perhaps employed by some hedge funds, managed futures and market-timers.

This definition implies a potentially broad constituent universe that allows the investor considerable discretion in identifying PAO opportunities in the HPT sub-portfolio mandated to pursue capital appreciation. Advisor practitioners seeking to implement HPT should exercise such discretion based upon a number of factors, such as their access, due diligence skills and core beliefs with respect to the viability of certain PAO asset-classes, strategies or products. As the moniker Venture Populist implies, my PAO allocations favor private investment in private venture due to the decisive historical performance of venture capital and private equity as an asset class and its proven role of being the greatest and most sustainable source of private wealth.

But the beauty of HPT lies in its adaptability as each investor will define their PAO universe according to their own beliefs, biases, professional skills, access to product  and deal flow…as long as those investments are truly characterized by an empirical and quantifiable positively-skewed risk/reward ratio.

Private investments in venture and early-stage companies are unmistakable asymmetric upside candidates as they are often vulnerable to a 100% loss but may also return three to twenty times on capital. Publicly-traded emerging growth companies are occasionally capable of delivering outsized (Lynch’s “10-bagger”) returns, as well.

But, what about managed futures and market-timers? The manufacturers, marketers and distributers of these so-called “absolute return” products clearly position them as effective portfolio diversifiers, citing their low correlation to long-only assets during Gaussian good times, but does anyone still fall for that line in light of correlations invariably coalescing amidst ever more frequent black swan drills?

Fact is, quantitative diligence reveals most managed futures and market-timers employ zero-sum game strategies with distinctively binary and symmetrical outcomes. They can lose or gain the same amount on each trade. Even if their quantitative models impose disciplined (per trade) stop-loss provisions the aggregate sum of losing trades can equal (or exceed) the aggregate of the winners….hardly asymmetric.

MPT would not have failed so miserably if the concept of diversification was not diluted and polluted by product pushers and manipulative mutual fund marketers. Achieving true diversification requires a higher standard. Amidst the new normal and an elusive equity premium, capital appreciation should be pursued via diversified portfolios defined by their breadth of investments with the potential for positive asymmetrical outcomes.

Album:   Boom Boom Pow, Black Eyed Peas, 2009

 In my last post I introduced an alternative asset-allocation approach for investors that no longer subscribe to the discredited models of traditional (strategic) asset allocation, Modern Portfolio Theory (MPT), Efficient Market Hypothesis and what pedestrians refer to as “buy-and-hold”  investing.

This new portfolio construction approach, Hybrid Portfolio Theory, is a unique and timely portfolio construction methodology that is distinctly disparate from MPT in that it employs two distinct capital pools: Portfolio A, the larger portfolio has the primary objectives of safety of principal, liquidity and income, and, Portfolio B that only allocates to private or public investments that exhibit the potential for positive asymmetrical outcomes (PAO) via exposure to positive black swans.

Last week Investment Advisor Magazine and Ameritrade co-sponsored a webinar that allowed me to introduce Hybrid Portfolio Theory to investment professionals. The call was well attended with nearly 500 registrations.

[You are welcome to listen to the archived call and view the presentation which is hosted at this link, or, you can simply view the Powerpoint, without the audio, here.]

We cut the call at the hour mark which means that many questions from participants that were in the queue for the Q&A portion were unable to be addressed. I welcome the opportunity to address your questions, comments and critiques and would encourage you to post them on the comment boards of the Hybrid Portfolio Theory post and I will reply in that forum.

If you would like to have a direct dialogue, please reach out to me via LinkedIN and we can schedule a private conversation.

After the call, I received dozens comments on HPT via LinkedIN. I was not at all surprised to hear from a number of advisors who had previously embraced a number of HPT core principles in their portfolios. I plan to introduce these advisors (and the manner in which they have adopted or adapted HPT to their portfolios) to VP readers in the months ahead.

Many of the comments received revealed that investment advisors were compelled by the concepts of HPT, but also had many questions about implementation and execution of the strategy at the client, portfolio and practice level.

For good reason…HPT is not as pie-chart ready as Modern Portfolio Fallacy.

Going forward, VenturePopulist posts will address issues associated with the implementation of HPT and defining the broad PAO opportunity set…with particular focus on private equity (angel investing and venture capital) investments.

Thank you for your all of your responses to HPT…the curious, the complimentary and the critical. I welcome and look forward to your comments on our boards.

Album:   What’s Next? Foster Edwards Orchestra, 1964

This  feature presentation introducing Hybrid Portfolio Theory was introduced in a 6.17.09 webinar hosted by Investment Advisor magazine and sponsored by Ameritrade that was attended exclusively by investment professionals.

If you would like to listen to the archived webinar (which includes the audio and some Q&A) you can do so at this link.

Album:   Feature Presentation, Kutt Calhoun, 2008

There is a better way to build investment portfolios than the methods presently employed by most investors and advisors.

Perhaps that is hard to imagine seeing as how well we have been served by Modern Portfolio Fallacies and the Efficient Market Hypocrisies, but if you have an open mind, there is a strong chance that these portfolio construction principles will resonate with you…particularly on the heels of what we have learned from the half dozen market meltdowns experienced since ‘87.

I know that the idea of a new asset-allocation model is intuitively tiresome…but if there was ever a time to revisit the prevailing conventional wisdom, it is now. This smarter portfolio approach places heavy emphasis on safety of principal, liquidity and income, yet simultaneously provides investors with compelling potential for capital appreciation.

I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors.

In HPT the investor allocates 100% of the assets into two distinct (hybrid) portfolios. The larger portfolio (A) represents 75-90% of the assets and is invested with the primary objective of liquidity, safety of principal and income. This portfolio is benchmarked against a blend of risk-free and short-term yield rates and invests predominantly in money markets, CDs, short-term muni’s and Treasuries.

The challenge of portfolio A is to maximize yield in bps and increase yield to the point that does not threaten the overall liquidity and safety of principal. With liquidity and safely of principal as primary objectives, that effectively eliminates allocations to high-yield corporate and junk bonds, REITs, MLPs, closed-end and utility stocks by the literal-minded HPT practitioner.

Why Bother with Stocks?

So, what is the source of return for capital appreciation in HPT? Not traditional equities. Stocks go up and stocks go down. That’s a symmetrical outcome that we now know empirically to be a bad bet unless you have a multi-decade investment horizon. Rob Arnott’s recent article “Bonds: Why Bother?” in the Journal of Indices emphatically settled the score.

Arnott proved that the 5% risk premium promoted by the financial services industry is at best unreliable and is probably little more than an urban legend. Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009. Going back 40 years to 1969, the 20-year bond investor still outperforms by a marginal amount, even with the Carter-era inflation and traumatic bond market in the seventies.

It is not debatable. Equities have not delivered their risk premium and are simply not worthy of their risk. Rather than pursing the laughably unreliable risk premium of equities, Portfolio B is exclusively seeking higher risk–higher return positive asymmetric outcomes (PAO). The Portfolio B benchmark is in the 10-20% range.

A PAO is defined by its ability to generate high double-digit or multiples of return on investment, as can be achieved by successful investments in venture capital, private equity, direct (angel) private investment in start-ups, small business, private manufacturing business, private real-estate, private debt, franchises, operating cash-flow businesses, as well as, publicly-traded emerging growth companies and leveraged option strategies or highly-specialized investment strategies such as managed futures.

The PAO mandate is broad but should ultimately be defined by a positively skewed risk-reward ratio, as well as, the practitioner’s sector expertise and due diligence resources.

The investor’s overall hybrid portfolio benefits by assuring that the vast majority of assets are not exposed to a downright bad wager relative to risk-free or short-term assets, as well as, unpredictable (yet, frequent) black swan events that decimate investor portfolios.

HPT should be engaged and implemented as a theory, not as an absolute rigid asset-allocation model. If the portfolio manager, advisor or investor accepts that; 1) current asset-allocation frameworks cannot successfully mitigate significant market exposure and do little to protect investors from unpredictable negative black swans, 2) investors are generally over-exposed to equities in light of the proven absence of any sustainable risk premium, and, 3) investors benefit from limited but diversified exposure to investments and strategies characterized by the possibility of positive asymmetric outcomes…this is a portfolio theory that you can adapt into your other core asset-allocation principles and values.

When adapting HRT to your own biases, the allocator can exercise discretion with respect to;

1. The A:B Portfolio ratio
2. The constituent opportunity set for Portfolio A–from short-term high liquidity, lower-yielding, shorter-term instruments to Treasurys, TIPS and munis
3. The consitutent opportunity set for Portfolio B–from private venture investments to publicly-traded emerging growth companies to specialized trading and option strategies
4. The benchmarks applied to the A and B Portfolios

Today, investors more than ever appreciate and welcome the notions of safety and liquidity. They no longer believe in the buy-and-hope asset-allocation models and “stocks for the long run” mantras peddled by talking heads. Moreover, the coveted HNW-investor demographic that you either aspire to, or presently serve understands and accepts the risk and liquidity realities of private investment in venture and enterprise. In fact, in most cases, such investment or employment is how they generated their private wealth.

Assuming the proper resources, advisors that embrace Hybrid Portfolio Theory (for appropriate investor portfolios) your advisory practice would benefit by;

• Delivering the services, results and sensibility that desirable HNW investment clients are actually seeking from advisors,
• Protecting your client’s assets and portfolios from incurring significant losses from exposure to unpredictable black swan events,
• Strengthening advisory-client relationships by developing a unique and connected client community within your practice, and,
• Competitively distancing your practice from the vast majority of investment advisory firms that can provide no evidence of a discernible value proposition.

I understand that this sounds provocative considering what investors and advisors have come to believe in after years of over-attentive care and feeding by the financial services industry. Yet, if you acknowledge the historical data,  the frequent and unpredictable impact of negative black swans and the notion of investing for positive asymmetric outcomes ,you should not be questioning the virtues of HPT as much as the critical issues of; access to the opportunity sets, due diligence, implementation and execution of the strategy.

Stick with us as we intend to tackle those issues in coming posts.

A more detailed Powerpoint presentation and audio webinar on HPT is available here.

Album:    Hybrid Theory, Linkin Park, 2001

The Black Swan by Nicholas Nassim Taleb holds its own among the most important investment books ever written. In it, Taleb argues persuasively that any sensible long-term strategy in a world dominated by extreme and unpredictable (black swan) events has to accept, and even embrace, that very unpredictability. It is poignant and timely advice for any investor and a must-read for investment professionals.

I met Taleb for lunch at Bice in NYC one afternoon about three years ago while I was heading Alternative Strategies for an investment management firm. I was interested in exploring the idea to engage Taleb as a sub-advisor for an investment fund that we were contemplating. I found him to be personable, enthusiastic, engaging and surprisingly modest.

I had read and re-read Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life before our meeting and I was looking forward to discussing his contempt for investment managers that sell themselves on their track record…a cynicism that I shared. But Taleb had just finished his final draft manuscript of The Black Swan and directed our discussion towards his treatise on asymmetric outcomes-the central theme of the unpublished tome that he brought along with him and referenced throughout our visit.

The notion of asymmetric outcomes, “I will never know the unknown since by definition it is unknown. However, I can always guess how it may affect me, and I should base my decisions around that”, causes Taleb to advise to seek out (investment) situations “where favorable consequences are much larger than unfavorable ones.”

That is a central tenet of Venture Populism and my advocacy of committing a portion of an investor’s portfolio to private venture-oriented investments. Like Taleb, I believe that effective investment portfolios should contain meaningful (and appropriate) exposure to positive Black Swans-such as private equity investments in emerging ventures and distressed companies.

In posts to come I will expand on this premise and propose a provocative new model for portfolio construction that balances the investor’s need to mitigate the asset-depleting impact of negative black swan events with simultaneous allocations that benefit from the potential of positive Black Swans and asymmetrical outcomes.

Many advisors now concede that Modern Portfolio Theory, traditional asset-allocation and buy-and-hold investing models have failed and investors are looking for improved approaches that preserve capital and manage unexpected risks more effectively without giving up on the prospects for capital appreciation.

The Black Swan is indeed a brilliant and provocative work. As the New York Times review summed, “It concerns the occurrence of the improbable, the power of rare events and the author’s lament that in spite of the empirical record we continue to project into the future as if we were good at it.”

We expect all swans to be white and are shocked when a black swan swims by…the same way that we were lulled into complacency with flawed risk management models and were then shocked when the market fell 50% and erased away trillions of wealth.

Investors and their advisors can build better portfolios that are for the most part insulated from the impact of negative black swan events, yet have simultaneous exposure to asymmetrical risk/return opportunities.

Album:   The Black Swan, Story of The Year, 2008

Broker Model Needs Repair (Financial Post)

“By charging you 1% annually to manage your money, a large portion of your wealth ends up in his or her pocket.”

Financial Advisers Face a Crisis of Confidence (Investment News)

“About 80% of affluent investors — that is, those with more than $500,000 in investible assets — are disgusted with their adviser because their adviser is spooked”

Album:   Read All About It, The Newsboys, 1988

In prior posts I have taken swipes at traditional asset allocation, buy-and-hold investing, the Efficient Frontier, the Efficient Market Hypothesis and Modern Portfolio Theory (MPT).

Sure, I am trying to be provocative, poke a little at advisor complacency and provoke polemic on the comment boards…but I am also sincere. MPT relies entirely on investment history for investment analysis and conclusions. These tired and discredited methods are rubbish…and have cost investors trillions.

It is encouraging to see evidence of advisor post-mortems in progress as some advisors are seeking not to repeat the mistakes of the past. I was also entertained by John C. who cracked on the comment board, “What’s over 50 years old and still considered modern?   MPT”

But pretty pie charts and Powerpoints are not so easily disposed of. As an anonymous critic incites, “The appeal of Modern Portfolio Theory in the investment advising community is its simplicity, graphic presentation value, and most of all, little or no investing judgment or skill is required; just pick, print, present, and hope; chasing efficient frontiers, hoping that investment history will somehow repeat itself, and just waiting for historical updates to generate new efficient frontiers to justify investment change.”

Nevertheless, some advisors are stubbornly standing by their man(tra).

Modern Lovers

Consider these edited comments that I received from Matthew K. in response to the Crisis = Opportunity post;

“MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade. Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals…Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?”

I cannot rebut a hopeless romantic, so let’s engage Matthew K. in a virtual volley with interlaced quotes excerpted from a FT article and a McKinsey interview with the especial epistemologist, Nassim Nicholas Taleb. Taleb is the author of two true investor instant classics and must-reads, Fooled By Randomnes and The Black Swan.

Taleb has a strong opinion on the matter of MPT and modern finance…and he is no modern lover:

MK- MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade.

NNT-We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology, without the aesthetics…In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction….I would ban portfolio theory immediately. It’s what caused the problems…Portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.

MK-Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals.

NNT-Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize… Every time I have questioned these methods I have been abruptly countered with: “they have the Nobel”, which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudoscience among financial institutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools.

Thanks, (virtual) Nassim. I will take the next one.

MK-Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?

VP-Of course, venture implies risk-taking… they are nearly synonymous. A venture investor is knowingly acknowledging and accepting an implicit and quantifiable serving of risk that is decidedly less than a range of positive (asymmetric return) outcomes. Perhaps investors would have been better served if their notion of the risk that they were assuming in their efficient frontiers was not muted (and implied to be mitigated) by the marketing machinations of MPT. CAPM is a future-oriented model yet it essentially relies on historic data to predict future returns. The Efficient Frontier? I have seen the inputs, I have seen the outputs…and I have seen the results…the efficient devastation of unsuspecting portfolios.

Album:   The Modern Lovers, The Modern Lovers, 1976