HH The Appropriate Portfolio Vs The Optimal Portfolio

“Perfect is the enemy of the good” – Adapted Italian Proverb

We all want the perfect portfolio, the portfolio that achieves the highest amount of return for the lowest degree of risk. But one of the inconveniences of a system as dynamic as a financial market is that it’s impossible to consistently maintain the perfect portfolio. This pursuit, unfortunately, causes more damage than good since it leads to increased activity, higher fees, higher taxes and usually lower returns. I have argued in my new paper, Understanding Modern Portfolio Construction, that this pursuit of alpha is misguided and that we should seek the appropriate portfolio as opposed to the optimal portfolio. Here’s my basic thinking:

There is an abundance of data supporting the fact that more active investors do not consistently generate alpha or excess return.¹

Alpha is elusive because it doesn’t exist in the aggregate and because we all generate the after tax and fee return of the aggregate financial markets. So, the diversified low fee indexer must ask themselves – if I want to be properly diversified and alpha is impossible to achieve in the aggregate then is this a pursuit I should bother engaging in? For most people, the answer should be no.

For most people, the generation of “alpha” is not a necessary financial goal. Asset allocators should be concerned with generating the appropriate return as opposed to the optimal return. This means building a portfolio that is consistent with your risk profile and managing it across time so that you maintain that profile while maintaining an appropriately low fee, tax efficient and diversified approach.

The pursuit of alpha generation not only reduces returns by increasing taxes and fees, but also misaligns the way the portfolio manager perceives risk with the way the client sees risk. Since the portfolio manager is benchmarked to a passive portfolio they likely cannot outperform they will often exacerbate many of the frictions that degrade portfolio returns all the while increasing the risk that the client will not achieve their financial goals.