PFP2519. A New and More Intuitive Way to Invest in Retirement: Dedicated Portfolios

Modern portfolio theory (MPT) stems from a 1952 article by Harry Markowitz based on his doctoral dissertation. MPT became the darling of the large Wall Street brokerage houses looking for a larger market share of the personal investing industry. It was easy to understand, easy to implement to gain scale, and had the aura of academic prestige. But Markowitz did not have individual investors in mind when he did his original research. He wrote his paper for institutional investors, as he later clarified: “The ‘investing institution’ which I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or mutual fund… …[but] reflection convinced me that there were clear differences in the central features of investment for institutions and investment for individuals…” Markowitz’s clarification, published in 1991, came a little too late. By then, MPT had become the dominant strategy used not only by Wall Street brokers but also by certified financial planners and other advisors whose training never even exposed them to alternative strategies such as dedicated portfolio theory (DPT). DPT is a better fit for personal investors, especially retirees who are in the “distribution” phase of life. For such investors, an “Income Portfolio” is built consisting of individualized ladders individual bonds (usually government bonds) in just the right quantities, maturing at just the right times to dedicated to matching the precise stream of withdrawals needed for the next five to ten years based on the cash flows specified in the individual’s financial plan (which is presumably comprehensive and built for the person’s lifetime). The rest of the funds are devoted to a “Growth Portfolio” consisting entirely of equities. As each year passes, equities may be sold to replenish the Income Portfolio to maintain the length of secure income stream of maturing bonds in perpetuity. If the market happens to be down enough that the probability of success is reduced (that is, if it falls below the “critical path” it must follow to ensure success), the replenishment can be postponed for another year or until it rises above its critical path. For those not yet retired and not withdrawing income from their portfolio, ladders of individual bonds held to maturity reduce the volatility that equities generate. That is one of the primary purposes of holding bonds, whether individually or in bond funds. One advantage of an individual bond is that when it is dedicated to being held to maturity, its intervening value is meaningless. Mathematically, one could say its volatility is zero since its yield to maturity is locked in once it is purchased if held to maturity. This talk with explain the dedicated portfolio strategy in detail.