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7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 6th Deadly Sin – Not-So “Modern” Portfolio Theory

7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 6th Deadly Sin – Not-So “Modern” Portfolio Theory
September 07
01:27 2016

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Pride (in the ecclesiastical world) – It makes a great deal of sense to have confidence in one’s self. That helps carry one through the inevitable hard times that occur in one’s life. On the other hand, this confidence should not become an arrogant overconfidence whereby one begins to believe one is all-knowing and infallible.

Pride (in the investment world) – Modern Portfolio Theory, (the arrogance to think financial markets are a hard science).

It’s one o’clock in the morning and your phone rings. At first startled, you’re soon consumed by a cold sweat as you realize middle-of-the-night phone calls usually mean something terrible has occurred. Slowly – and reluctantly – you pick up the receiver. With a firm meekness, you answer, “hello?” only to be confronted with the sound of heavy breathing.

It’s your best friend from high school. You haven’t heard from him in years. He’s in trouble. He begins to tell you his story. He’s spent years trying to come up with a sure-fire way to predict the winner of the Superbowl. After many exhaustive tries, he finally discovered the best way to predict which team would win in any given game. He explains, “We all want to know which team will win. Now, what does it take to win? It takes touchdowns and field goals. And what’s required before you score? You’ve got to move the ball down the field. This means accumulating a lot of total yards on offense. Now, I’ve tested and tested this idea, and I’ve found it’s the best way to predict the winner in any given game.”

“Well,” he continues, breathing heavier with each phrase he utters, “I figured if it’s the best way to predict the winner, I couldn’t lose. So I bet everything I own on the Superbowl. I figured out which team was most likely to accumulate the most total yards and bet the farm that they should win. Well, you know what? I was right! The team I picked DID accumulate the most yards.”

“Congratulations,” you say as you grow miffed that some old buddy has the gall to call you in the wee hours of the morning just to brag. Still, curious, you decide to take the bait and ask, “So how much did you win?”

“Win?!” your friend exclaims nervously. “What makes you think I won?”

“You said you picked the right team!” you quickly counter as your confusion sobers your sleepy brain. “You said you picked the team that got the most yards!”

“Sure I picked the team that got the most yards!” chimes in your chum, “but you know what? They didn’t score the most points! I lost! I lost everything.”

*                *                *                 *

What if I told you that something vital to top business schools, the financial services industry, your business and your clients’ success and satisfaction doesn’t work as advertised? Would you be interested? Would your clients blame you when they discover it doesn’t work? Would you (and your clients) like to know how Wall Street’s embrace of it hurts you and your clients? Would you like to be absolutely sure you and your clients are not making these same mistakes? Would you like me to reveal some affordable techniques you can use to protect both your clients and yourself?

Every day, fiduciaries, financial planners and employees in 401k plans – whether they realize it or not – use a tried and true method to allocate their assets and, beyond that, make their investment decisions – Modern Portfolio Theory (MPT). Sure, you know its founders won a Nobel Prize. Yes, you know most popular software applications use it. Heck, you probably even know the Department of Labor, in an Advisory Opinion released in December 2001, referred to it as “generally accepted.” Yet, there’s only one problem. It doesn’t work.

“Yea, yea,” you’re saying to yourself. “Old news. But there’s nothing really better and besides, everybody else uses it.”

Would it surprise you to learn this excuse may not pass the rigors of fiduciary duty?

A little over a year ago we left you a clue in the final sentence in our series on asset allocation (see “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 5th Deadly Sin – Misapplied Asset Allocation,”, June 9, 2015). Did you pick up on it? Sins, like other bad habits (and interest), have a way of compounding on one another. Find one and there’s a good chance there’s another one – a larger one – behind it. In fact, if you dig deep enough you’ll find the tap root. Identify this mother lode, and you stand a good chance of solving the root problem – and all the other problems that stem from it.

Before you solve a problem, though, you need to determine how we got there in the first place. Return tomorrow and read Part II of this five part series: “The Road to Vainglory: How MPT Went Viral”

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 6th Deadly Sin – Not-So “Modern” Portfolio Theory
Part II: The Road to Vainglory: How MPT Went Viral
Part III: Statistics Goeth Before a Fall
Part IV: All I Gotta Do is Act Rationally
Part V: Beyond MPT – Are We There Yet?

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s (including information on the new wave of plan designs) every 401k plan sponsor and service provider wants and needs to know. Alternatively, would you like to help plan participants create better savings strategies? You can buy Mr. Carosa’s latest book Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort right now at your favorite on-line or neighborhood book store.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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