This is the first in a series of posts about my investing philosophy – Risk-Aware. Risk is the permanent impairment of capital. While risk is often viewed as something that happens to a portfolio, it can also be created through the actions of a portfolio’s manager/owner.
Be compensated for Risk
There is no such thing as risk-less return, but there is such a thing as return-less risk. While the risks and returns of asset classes are not necessarily related, the relationships that do exist are constantly changing and not linear.
You are always compensated for your behavior, especially if it is bad.
Luck plays a bigger role than anyone wants to admit. One aspect of luck lies within sequence of returns risk. Buying and holding a 60% S&P 500 / 40% Barclays Aggregate portfolio (60/40) would have lost 22% during the ten years following March 1999 (I am cherry-picking the end to coincide with the market bottom of the Great Financial Crisis). Rebalancing can offset this somewhat. A 60/40 portfolio rebalanced quarterly would have been about flat (lost 0.64%).
Most people don’t have a lump sum to invest all at once. They invest portions of their income with each paycheck which can be looked at as diversifying away some of that sequence of returns risk. It stinks that you had all that money socked away at the last market peak, but you were still putting money into your 401k during the bottom, right?
We can also create our own luck. What if you bought AMZN at IPO? That lottery ticket would have grown 101,475% (through September 2018)! However, just like a lottery ticket, the odds of winning are incredibly low and picking stocks should be done with mad money for entertainment rather than to get rich. Besides, you wouldn’t have held onto AMZN long enough to recognize all 101,000 percent of that return since the stock lost 20% or more 7 times, including an epic 90%+ drop during the bursting of the tech bubble. So, yes we can create our own luck, but luck from trading our portfolios is usually bad. The luck we create by saving is good.
Pick the Best Set of Problems
The financial services industry thrives on selling new strategies to people who don’t know better. This is a case of “When the ducks are quacking, feed them“. Investors (it’s tempting to say retail investors, but supposedly sophisticated investors are just as guilty) have an insatiable appetite for the next best investment. They drool over the new, the shiny, the complicated, the pedigreed, the exclusive. These vanity or aspirational investments are in high demand. And they are garbage. Pundits love to say about the markets that “the easy money has already been made”. This is never true. The easy money is made selling the next best thing to suckers. S&P 500 is down? International stocks trading sideways? Corn futures skyrocketing? Wall Street will create a product for that and let me tell ya, the backtests look great.
Do you really need all this? The biggest open secret on Wall Street is that the 60/40 (60% S&P 500/40% Barclays Aggregate) portfolio is ridiculously hard to beat. This is perhaps the dumbest strategy outside of ‘Buy the S&P 500 and hold it forever’, but it crushes almost all who stand in its way.
You can make investing as complicated as you want, but the fact remains that even the people who trade securities for a living have trouble keeping up with the markets. All that energy is better spent on activities that truly add value and protect wealth such as tax planning or estate planning.
In my experience (note: the plural of anecdote is not data), the longer the prospectus and disclosure documentation for an investment, the worse the thing behaves. You should print out the documents and carry them around with you for 72 hours before you buy (or before you are sold) a private equity, structured note, or other over-lawyered investment.
Have a Too Hard Pile
Warren Buffett famously has a TOO HARD box on his desk. If an investment idea winds up in there, he’s not damning it as bad so much as admitting he can’t understand it. Uncle Warren doesn’t like to invest in stuff outside of his circle of competence and that has worked pretty well for his investors. It’s better to pass up a good idea you don’t understand if you’re also throwing out the investments that will cause heartburn. Complexity increases the likelihood of red flags.
Trading not to Lose
Trading to avoid short-term pain boosts risk.
Risk Capacity versus Risk Tolerance
Risk Capacity is an objective calculation. Input predictions about asset class returns and standard deviations, your beginning value, savings rate, and required ending value. An optimizer will spit out a required return and efficient asset allocation.
Risk Tolerance is subjective. Sure, you might have capacity to take on a 50% drawdown in the middle of your investing life, but you might not be able to tolerate it. An optimizer can’t tell you what it feels like to lose 10, 20, 30% of your life’s savings. Likewise, it won’t tell you to reduce risk if you meet your goals early. There are some things you can’t know without experiencing them yourself. Like Mark Twain said, “A man who carries a cat by the tail learns something he can learn in no other way.”
Investors should accept that emotion exists and is a factor in risk/reward. This is messier than crunching numbers in a spreadsheet, but reduces the risk of terrible timing (selling low, buying high).
Photo by Infomastern