Financial Literacy - Retirement income planning
Walter Woerheide
Buy-and-hold investing not dead after all

Spotlight: Walt Woerheide

It turns out that rumors of the death of buy-and-hold investing strategies have been greatly exaggerated. At least that's what Walt Woerheide believes when it comes to long-term strategies for individual investors who lack a crystal ball or other prognostication skills.

The professor of investments at American College and co-author of the financial professionals' textbook "Fundamentals of Investments for Financial Planning" believes most people can best benefit from a passive investing strategy, and that modern portfolio theory leads to the efficient frontier, that virtual place where investment return potential is maximized and risk is minimized. He defends the theory against naysayers who found fault with it in the recent bear market.

Bankrate asked the professor to explain modern portfolio theory and to clear up a few questions on asset allocation and rebalancing your portfolio.

At a glance
Name: Walt Woerheide, Ph.D., CFP
Hometown: Bryn Mawr, Penn.
Education: BA from Brown University and Ph.D. and M.B.A. from Washington University
Career highlights:
  • Vice president of Academic Affairs, Dean, at American College.
  • Holder of the Frank M. Engle Distinguished Chair in Economic Security Research and a professor of investments.
  • Oversees the content development of The American College's Certified Financial Planner (CFP) certification curriculum.
  • Author of "Introducing Personal Finance" and co-author of "Fundamentals of Investments for Financial Planning," textbooks used to educate financial services industry professionals.
  • Worked for a year as a visiting scholar at the Federal Home Loan Bank Board.
  • Serves as an associate editor for the "Journal of Financial Service Professionals" and serves on the editorial board of the "Financial Services Review and Business Quest" and the "Journal of Financial Planning."
q_v2.gif What is modern portfolio theory?

a_v2.gifWhen we talk about modern portfolio theory, we're talking about the idea of dividing investments into categories and then we're talking about estimating several statistics for each category of investment.

You think of each category as a single investment so you might have a category like small-cap value stocks, large-cap growth stocks and so on. So you think of all the different investments and categories and then you estimate three statistics -- sort of three, it's actually a ton more.

You estimate the expected return on each category of investments, the standard deviation of return for that category, and then you estimate the correlation coefficient between the returns on that particular category and every other category of asset classes.

Then you use a very elaborate mathematical model called linear programming that allows you to estimate optimal combinations of the different categories. And those optimal combinations are what we call the efficient frontier.

So in modern portfolio theory, you're trying to construct the efficient frontier and then figure out which portfolio in that efficient frontier is the one that best serves your needs in terms of your desire for return and your desire to minimize risk.

Even if you and I agreed what the efficient frontier looked like, we still may end up with different portfolios because my optimal risk-return trade-off is different than your optimal risk-return trade-off.

And so you identify the optimal portfolio and pick the one that is best for a particular client and then engage in asset allocation or divide the portfolio into those asset classes.

And that is, in a nutshell, modern portfolio theory.

q_v2.gif Not everyone thinks asset allocation is the most efficient way to invest, particularly given the volatility of the past year. What are some of the other theories that people subscribe to when it comes to investing?

a_v2.gifAsset allocation is a very passive strategy. It says you pick the optimal portfolio, you allocate your assets and you hold them.

It's also a buy-and-hold strategy. Everybody who has followed a buy-and-hold strategy over the last year and a half saw about 30 (percent) to 40 percent of their portfolio value knocked out over the past year. So that leads people to say, "This is a dumb strategy."

Then what are you going to do? The alternative has to be simply that you start trying to anticipate the market and start dynamically moving your money around the various categories.

I think a lot of the people that are poo-pooing modern portfolio theory or asset allocation are also advocating much more allocation to what we call the alternative investments. In truth, alternative investments could very well be a legitimate asset category within the modern portfolio theory context.


Modern portfolio theory does not say the asset categories must be limited to stocks or stocks and bonds, but most of the time when people do it, they do limit their allocation to stock and bond portfolios. But that is not what the basic theory says.

Anybody who says that asset allocation failed because my stock and bond portfolio didn't do very well is unfairly criticizing the basic theory.

I've read some discussions of people poo-pooing modern portfolio theory and asset allocation and they still end up presenting ideas consistent with the theory -- that is, you get more diversification by going to these alternative investments.

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