The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

In the beginning . . .

05/16/2018

. . . there was Benjamin Graham, the father of investment management and author of the dryly titled Security Analysis.  He was the mentor for Warren Buffett.  Graham advocated a “bottoms-up” approach to investment management, which requires exhaustive analysis of all financial statements, physical inspection of all facilities, and probing interviews with senior management.  The criticism of this approach is that investors get the best companies but maybe in the worse sectors or countries.  Most Chartered Financial Advisors (CFAs) are disciples of this approach.

Then, there was Harry Markowitz, the father of Modern Portfolio Theory (MPT), which won the Nobel Prize.  He advocated that a portfolio of stocks should be shaped to get the best return for the amount of risk taken.  He found that a portfolio of both large and small companies offered the best return for the least risk, but in a constantly-changing ratio.  It is a “top-down” approach, finding the worst-performing stock in the best-performing sector will out-perform the best-performing stock in the worst-performing sector.  Most Certified Investment Management Analysts (CIMAs) are disciples of this approach.

Since then, there has been an endless stream of improvements to MPT, such as “passive versus active” investing, factor-based investing, etc.  But, these improvements were designed to improve the growth prospects of portfolios, ignoring the fact that an increasing number of investors are more focused on income than growth.

Now, along comes Dedicated Portfolio Theory (DPT), which calls for two portfolios – one dedicated to growth and one dedicated to income.  The income portfolio contains individual bonds, not bond funds.  Assuming at 4% distribution rate, an investor could, for example, put five years or 20% into the income portfolio, preferably with zero-coupon bonds maturing once a year.  Maintaining this dedicated income portfolio is more important then the growth portfolio.  At the end of each year, one must decide whether to roll funds from the growth portfolio by a technique called Critical Path, which is beyond the scope of this blog.

My impression is that DPT offers some cold comfort to those investors who fret endlessly about having enough income.  DPT is an interesting but over-hyped concept.  MPT will still be employed to manage the growth portfolio . . . thankfully!  DPT is no big deal!

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