John Mulvey's investment tips to enhance portfolio returns

John Mulvey is a leading expert in large-scale optimization models and algorithms, especially financial applications. He has implemented integrated risk management for many large financial companies, including American Express and Pacific Mutual.

His recent work involves the area of alternative investments, their relationship to traditional assets, and dynamic investment strategies to enhance performance. He has edited five books and published over 170 papers

Mulvey wrote some golden rules for global investing which can help investors amass solid returns.

Mulvey says investors should link their assets, liabilities and goals in an integrated fashion.

"A couple saving for retirement should put together a savings and investment plan with a view of their consumption requirements. Uncertainties should be addressed in the planning process," he says.

Mulvey says according to traditional portfolio theory risk is equated with volatility or standard deviation of investment returns."However, a young investor with a long horizon will take on less risk by investing in equities, as compared with an elderly person (also investing in equities) who needs liquidity this year. Measuring risk requires an understanding of the investor’s goals," he says.

According to Mulvey, the Markowitz mean variance model is generally posed as a single period model.

"This approach, while simple, misses an important dimension since it is a static approach to investing. It is better to conduct a dynamic analysis in which the investor re-balances his portfolio at the beginning of each period. Dynamic analysis will give different recommendations than a static model," he says.

Mulvey believes within a dynamic investment model, the most aggressive side of the efficient frontier consists of a set of high returning assets.

"The investor must re-balance his portfolio to the target mix at the beginning of each period. This fixed-mix approach can provide higher returns than any single asset category by taking advantage of the market’s natural volatility. In fact, highly volatile assets with high growth are sought after," he says.

Mulvey says HNI and institutional investors focus on asset allocation as a critical aspect of investment planning.

"Any investor can readily employ a passive index approach to investing within an asset allocation framework. The passive portfolio provides a benchmark for active management. Active managers are paid to beat their benchmark. In many cases, the active managers do not beat their benchmarks due to high fees and other causes," he says.

Mulvey says a portfolio model is dependent upon a set of parameters, such as the equity risk premium which are determined by analyzing historical returns in conjunction with current market conditions and expert opinion.

"Blending these aspects together can be difficult. Recommendations of a portfolio model should be stress tested. The final recommendations should be robust with regard to the assumptions," he says.

Mulvey says the recommendations of an investment model should be explainable in common sense terms but any model suggesting an outcome that is too good to be true is likely to be flawed.

"How does the model react to changing market conditions? What are the projected ranges on the upside and the downside? Optimization will attempt to exploit any advantage, without regard to the practicality of the strategy. Care must be given to the output of an investment model," he says.

Mulvey says investors should diversify their assets with their liabilities and goals.

"For instance, a pension plan must make contributions when their assets fall below the market value of their liabilities. These contributions can be difficult to make when the economy is experiencing a recession. Similarly, an individual investor should protect their own surplus by finding assets that are correlated to their long-term goals," he says.

Mulvey says there are proposals to develop deep ‘mathematical’ methods for forecasting the returns on financial assets, such as stocks, bonds, and currencies.

"These computer systems depend upon a complex set of equations that involve feedback, highly nonlinear functions and other exotic techniques. The investor is told that the model is too complex for understanding the underlying approach.

Beware of these black box systems. Investors should be able to understand the underlying methodologies," he says.

Mulvey says the goal of a planning system is to develop insights towards a plan of action.

"The investor must implement their financial plan and stick with it during both good and bad periods. Changing strategies during strong market moves generally leads to poor performance," he says.

(Disclaimer: This article is based on John Mulvey's book " "Optimal Financial Decision Making under Uncertainty.")