TPS and Modern Portfolio Theory

Assumption

Given an investor's investment horizon, he or she maximizes terminal wealth and minimizes overall investment risk.

Results from MPT

An investor's risk will be minimized by diversification. Clearly, not every investor has identical risk preferences. So, how an investor would diversify depends on his or her preferred risk, which will eventually determine his or her preferred asset allocation and hence, the portfolio's expected return.

One of the major findings in MPT is that the process goes through two separate procedures, known as the Separation Theorem. First, an investor must form a portfolio of risky securities. Once the investor finds that portfolio, the portfolio will be combined with a risk-free asset. An optimal combination between the risk-free asset and a portfolio of risky assets will achieve the highest return for the overall desired level of risk. Presumably, the best portfolio of risky securities is the one, which will duplicate the returns on the market benchmark index. So the conclusion is that investors should buy an index fund and combine it with a risk-free asset. However, theory also suggests the following:

Any mutual fund in the market should be perfectly positively correlated with the return of the market index, although the fund's risk-return profile may differ from that of the market index. Thus, one is left with the choice to buy mutual funds directly or to combine an index fund with a risk-free asset. This justifies recommending investors buy mutual funds in an "Advice-Based Planning" platform according to their risk preferences.

Problems in the Actual Application of MPT in Real World Investing

The true market index may not even exist and is generally unknown to institutional and individual investors alike.

Not every investor has the same investment horizon. In fact, some people invest sequentially instead of for a fixed time period and getting out completely.

How does TPS^TM work?

TPS^TM assumes that those with similar investment styles and investment horizons must have the same optimal portfolio. So, the basic analytical structure employed in arriving at an optimal portfolio in MPT must hold true. The TPS^TM system follows the mathematical approach exactly identical to ways in which to find an optimal market portfolio in MPT. It is a continuous-time stochastic process model.

On the other hand, investment managers, who try to compete with the performance of any market benchmark, may have to frequently rebalance their portfolios. For example, if an investor wishes to mimic the performance of the S&P 500 Index, his or her portfolio of 10 stocks must be rebalanced frequently, as long as the transaction costs of doing so are less than profits. A typical fund marketed in the United States, for example, has about 20 stocks and sometimes even fewer than 20. The TPS^TM engine makes it possible for amateur investors to create and manage their own funds like professionals.

The market may not be perfectly efficient in the presence of insider trading and other illegal activities. However, we believe that the market is efficient, in the sense that the information relating to any market irregularities seems to be promptly reflected in security prices. The TPS^TM system is a model built around the notion that the market is efficient.

If the market were efficient, there would be no single, smart individual who will do significantly better than others in the stock market on a daily basis. Consequently, picking a particular stock would be a totally wasteful exercise. What we do not do is pick individual stocks, which is not proven to work; instead, we choose portfolios of stocks. This is what MPT teaches us. What we mean by picking a portfolio is to select an optimal combination among stocks. Just as the chemist finds that water consists of two units of hydrogen and one unit of oxygen, we believe that a certain proportion of individual stocks will result in an optimal portfolio, which will give the lowest risk and the highest return.

What is even more important is the fact that in an efficient capital market, if someone consistently makes a lot of money, everyone else in the market will follow suit. So if a particular mutual fund performs well, everybody buys it; and sooner or later, nobody makes money. The whole idea behind TPS^TM is to construct individually tailored portfolios suitable to a particular person. This is possible at a cost. The cost is whether or not an investor is able to monitor his or her portfolio's performance at all times. If this monitoring cost is acceptable to investors, TPS^TM offers a choice of building wealth strictly on their own terms.

Last but not least, TPS^TM is a mathematical model that is proven to work. So sit back and effortlessly build your wealth!

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