"More than education was needed to empower individuals to invest with confidence – also needed was innovation in the form of a fundamentally different approach to investing." - Leland Hevner, President, National Assn of Online Investors
[Within the volatility, uncertainty and change happening throughout the financial services industry, there is a growing movement questioning and re-thinking everything about the investment process itself. Taking this changing mindset directly to retail investors is Leland Hevner, President and Research Director at the National Association of Online Investors - a leading investor education, investment research and financial consulting organization. Their mission is to empower individual investors to invest with confidence and to provide financial organizations with innovative investment solutions that will give them a distinct competitive advantage in the eyes of the public.
The Institute for Innovation Development believes his application of the proven innovation development tool of “Design Thinking” to the investing process - starting from the individual retail investor’s perspective - provides an excellent example of a structured process on how to rethink established investing practices. Financial professionals would be well advised to understand the research and client engagement process that he took, along with, the message he is bringing to individual investors and the industry at large.]
Hortz: Why do you feel investing today is dysfunctional?
Hevner: The field of investing is predominantly stuck in the past. We are told by many financial professionals, including most roboadvisors, that the only way to invest is by using a methodology called Modern Portfolio Theory (MPT). This is an approach to portfolio design that was introduced way back in 1952! Markets have changed significantly since then while MPT has barely changed at all, and it is no longer relevant to individual investor needs in today’s volatile, uncertain and stressful markets.
When the stock market crashed in 2008, I watched in dismay as the MPT portfolios, that I was teaching my students to create at that time, were crashing along with the market. At that point I paused all NAOI education efforts as I realized that more than education was needed to empower individuals to invest with confidence – also needed was innovation in the form of a fundamentally different approach to investing.
Hortz: What, specifically, did you determine about Modern Portfolio Theory that doesn’t work?
Hevner: First, MPT dictates that portfolios be designed to match the risk tolerance of each investor. The problem here is that determining a person’s risk tolerance is a massively subjective task and hard to quantify using traditional risk assessment methods that ask questions such as “If the stock market fell 10% in one week would you sell your stocks, buy more stocks or do nothing?” Most individual investors are not prepared, or fully think out, answers to questions like this. But, unfortunately, the answers to risk tolerance questionnaires determine a person’s portfolio design and, thus, their financial futures.
Second, the goal of MPT is wrong for modern markets. Instead of designing portfolios to meet the risk tolerance of individual investors, I believe that portfolios should be designed to produce maximum returns with minimum risk in all economic conditions. In other words, portfolios should be “market-sensitive” instead of “investor-sensitive”. By having the wrong goal, MPT methods produce static portfolios that neither enable investors to take full advantage of today’s dynamic markets nor protect them from major market downtrends.
Hortz: What first steps did you take in fixing those problems?
Hevner: As to first steps, I didn’t start with the investment process as most of the industry does, I started by working with the people that the new investment process was meant to serve. I followed a modern innovation and R&D process called “Design Thinking” which forces you to challenge assumptions and create better ideas by keeping the customer continually involved in the development effort. The steps we used were:
Step 1: Identify the true problem to be solved by defining it based on feedback from the investing public. The NAOI is uniquely positioned to do this as we have direct access to hundreds of NAOI members representing a comprehensive cross-section of the investing public. Input from our user group defined the initial goal-set to include a simplified trade decision process, higher returns with less risk, lower management fees and absolute protection from market crashes.
Step 2: Generate ideas for potential ways to meet these goals based on an examination of existing research and brainstorming innovative new approaches.
Step 3: Propose tentative solutions and build prototypes based on them. Test each extensively, incorporating feedback from individual investors, to identify the "best" proposed solution
Step 4: Document the solution in detail and establish standardized rules for implementing & managing it
It is important to emphasize that our research and development process was not one in which we took the initial goals of the investing public and came back later with a final solution. Design Thinking requires the continued participation of both users and researchers in an iterative process filled with feedback loops. Only via this ongoing, bidirectional information flow were we able to ultimately create a satisfactory solution that met the goals of the investing public.
Hortz: What was your core investment premise and where did that lead you?
Hevner: From the start I knew that any new approach to investing capable of meeting the goals of retail investors would need to be based on logic developed from the observation and analysis of historical market price data. As I studied decades of data I came to the conclusion that all we can know about equity price movements with a high degree of confidence is that they are cyclical - they move up and down over time. We also know that the prices of different asset classes and markets move up and down at different times. This led me to the premise that at all times and in any economic conditions, positive returns exist somewhere in the market. My task then became to build an investment type that could find and capture these returns in a rules-based, repeatable manner.
After extensive R&D we created a new investment type that validated the premise and met user goals. We called the new investing approach “Dynamic Investment Theory” (DIT) and the investment type that it creates, “Dynamic Investments” (DIs).
Hortz: How does a Dynamic Investment work?
Hevner: The Dynamic Investment structure is remarkably simple. It is a derivative investment vehicle that combines Exchange Traded Funds (ETFs), Mutual Funds, or any liquid investment vehicle in an intelligent, dynamic structure. It has three design elements. The first is called a Dynamic Pool into which designers place ETFs or other liquid vehicles that track the asset classes and/or market areas where they want the DI to search for positive price trends. The other two variables are a very simple: a Trend Indicator and a Review Period.
DIs are designed to require minimal time and effort to manage. At periodic Review events, typically done quarterly, the DI uses the Trend Indicator to rank, as an example, the ETFs in the DI’s pool of potential purchase candidates. Only the ETFs with the strongest upward price trend are bought and held until the next Review event when the process is repeated. Thus, all trade decisions can be easily made based on an objective observation of easy to find market data, not on risk-laden subjective human judgments or complex computer programs, as many are today.
Hortz: How do Dynamic Investments perform?
Hevner: Extensive testing shows that the DI model works amazingly well. As an example, the simplest possible DI which holds only a Stock and a Bond ETF in its Dynamic ETF Pool and rotates between owning each based on their price trends, earned an average of +29% per year over the period from the start of 2008 to mid-August 2018. And these returns were achieved with minimal risk. In contrast, a traditional MPT portfolio with an allocation of 60% Stocks / 40% Bonds earned an average annual return of less than 7% during the same time period with significantly higher risk!
Hortz: How do you respond to someone who questions this type of relative return?
Hevner: Once MPT constraints are lifted, results that we have been told are told are impossible, suddenly becomes probable. Think about the differences here. First, a DI strives to hold ONLY ETFs that are moving up in price. MPT portfolios are designed to hold both winning and losing investments at all times. DIs are capable of changing the ETFs they hold based on a periodic sampling of market trends. MPT portfolios are static; they are blind to market movements. And, as a third reason, DI trades are made based on objective observations of market data while MPT portfolios only change based on human judgments that inject a massive risk element into the trade decision process.
Hortz: That sounds reasonable but what do the skeptics say?
Hevner: I’ve heard numerous reasons why DIs cannot possibly work and they all fall flat. The most frequent issue is the tax penalty related to frequent trading. In response I show that even after short-term capital gains taxes are deducted from DI returns they still provide returns that are multiple times higher than buy-and-hold, MPT portfolios. Also, most retail investing these days is done in retirement/tax-deferred accounts where short term capital gains don’t apply.
The next objection I hear is that people can’t “time the market” with success. I agree, people can’t. But DIT doesn’t ask them to. DIs work based on the observation that market trends can reliably predict future price movements in at least the short term. Finally, people say that this must be a trading system that will work for a short time and then stop. My response is that DIT will work as long as asset and market prices are cyclical. And no amount of “over-use” will eliminate that.
Hortz: Does anyone else offer the methodology that you are suggesting?
Hevner: Yes, a few organizations offer some form of trend-following / momentum strategy. But my research into their methods shows that none do it as simply, as profitably, or as reliably as the NAOI model. Remember, a goal set for us by the investing public was that the investment process be simple, eminently understandable and doable by the average investor with no black-box methods, intensive research or complex computations involved. DIs meet this goal. Other offerings do not.
Hortz: Do you see Dynamic Investment Theory replacing Modern Portfolio Theory portfolios in the future?
Hevner: It has the potential to replace MPT in its entirety, but most likely DIT will serve as either a supplemental or an alternative approach. With the introduction of DIT and DIs, investors now have choices for a portfolio design approach – these being the use of MPT, DIT or a combination of the two. Over time, the investing public will determine which approach becomes dominant. I believe that when individuals learn about the advantages of Dynamic Investments, the demand for them will grow. At that point financial organizations that meet this demand will thrive, those that don’t may struggle.
Hortz: Besides enlightening and empowering your retail investor members, how are you trying to engage and what are offering to the incumbent, mainstream financial services industry?
Hevner: The financial services industry should not view DIT and DIs as a threat but rather as a gateway to a vast new world of opportunities and profits. Because DIs meet the goals of the investing public, they will entice millions of potential clients to enter the market. These are people who are now not active investors because of the uncertainty and risk they see as being inherent in the markets and the ineffective use of MPT-based portfolios. The high returns and risk reduction elements of DIs mitigate these fears. For this reason alone the industry should embrace DIT. But there are other reasons as well.
New, powerful DIs are easy to create, bypassing the time, cost and effort of developing new ETFs or mutual funds. They are formed by simply combining existing ETFs, mutual funds, or other liquid investment vehicles in the DI structure. As a result, investment product developers and advisors will be able to expand their product lines virtually overnight and offer dynamic portfolios that perform far better than the MPT portfolios used today.
To enable financial organizations to take full advantage of the coming Dynamic Investment Theory revolution, the NAOI offers DI education seminars, design classes, and customized consulting services. We also welcome R&D partnerships aimed at developing new methods and applications within the DIT framework. Interested parties can contact me at LHevner@naoi.org.
The Institute for Innovation Development is an educational and business development catalyst for growth-oriented financial advisors and financial services firms determined to lead their businesses in an operating environment of accelerating business and cultural change. We position our members with the necessary ongoing innovation resources and best practices to drive and facilitate their next-generation growth, differentiation and unique community engagement strategies. The institute was launched with the support and foresight of our founding sponsors - Pershing, Voya Financial, Ultimus Fund Solutions, Fidelity, and Charter Financial Publishing (publisher of Financial Advisor and Private Wealth magazines). For more information click here.