Thinking Coherently for Everyone

Tuesday, February 14, 2012 » posts.tags:

The core idea of Maslowian Portfolio Theory explained very short and simple.

Much research has been devoted to a better understanding of financial markets. Much less studies are available about how to adapt an investment portfolio to the needs of a person.

Actually, Markovitz' mean-variance criterion (formulated in 1952) is still the dominant line of thinking. This paradigm where each investor has one investment portfolio that should cater for all investment goals, was also the base of recent legislation such as MiFID, FINRA and to some extend UCITS IV.

All those regulations use the concept that one investor has one risk profile and that volatility captures the concept “risk”. Doing so, they mostly ignore the different time horizons, importance and relevance of different investment goals. But worse, they have to rely on magical thinking and rule of thumb to match this mysterious risk profile to investments. When using a target-based approach it becomes possible to make reasonable assumptions about the different sub-portfolios and this should lead to more robust results.

This PhD puts financial investment into perspective: the investor’s perspective. The result is a new normative portfolio theory which confirms Behavioural Portfolio Theory, draws attention to the importance of asset-liability matching, and offers a natural framework for investor-adviser dialogue and mathematical portfolio optimization.

In this system investment goals, not investor psychology, drive investment advice; “risk” depends on the goal (often inflation-linked), and may be different in each sub-portfolio. Hence the ruling paradigm in which each investor has a single risk profile can be a misleading and dangerous simplification.

(Yes it took me more than 500 pages in the book with the same name)