I share my own portfolio and investment philosophy as an example of investing without a map. Plus, why I don’t use peer-to-peer lending platforms such as Lending Club and Prosper.
In this podcast, you’ll learn:
- What my asset allocation looks like over time.
- Why I hold so much in cash.
- What it means to wait for a fat pitch in investing.
- Examples of mistakes I have made investing.
- How changing your asset allocation over time is different from trying to time the market.
- How peer-to-peer lending platforms work and how they differ from direct lending.
My Historical Asset Allocation
Note: This asset allocation graph is for general education purposes only and should not should not be construed as investment/trading advice.
Having trouble distinguishing the colors in the above chart? Click to download data and graph
Focus On The Extreme, Not The Average
Last week, I shared how modern portfolio theory (“MPT”) was an inaccurate map used by many financial advisors, including myself for many years, to help clients choose “optimal” portfolio mixes (i.e., the allocation split between stocks, bonds and other asset classes).
The justification I used and others continue to use is an inaccurate map is better than no map at all. At the end of the day, if modern portfolio theory helps a client to diversify their portfolio, what harm could there be?
The harm in relying on this inaccurate map is it can lead individuals to be too highly exposed to extreme negative events.
What’s Wrong With Modern Portfolio Theory
The problem with modern portfolio theory is it assumes market returns congregate around the average expected return much more than they actually do. In other words, MPT assumes exceptionally good or bad returns are extremely rare.
MPT also assumes returns in one year do not effect returns in the next. That a given year’s return is independent from the return in the previous year.
Finally, it assumes investors are rational agents who are all alike.
The truth is exceptionally good and bad returns happen much more often than the theory predicts, and these extreme events tend to clump together rather than be spread out randomly.
A Bumpy Ride
When flying in an airplane, a jolt due to air turbulence tends to be followed by another and another until eventually a period of smoother flight ensues.
Similarly, in financial markets, one period of high market volatility tends to be followed by another, at which point markets calm for a time before getting bumpy again.
Why is this important?
Because with MPT, individuals tend to focus on the average expected return rather than their exposure to extreme events.
Benoit Mandelbrot in The Misbehavior of Markets writes “What matters is the particular, not the average.”
Nassim Nicholas Taleb explains it this way, “Risk management is less about understanding random events as what they can do to us. Risk is in the tails not in the variations .”
When updating the operating system on our computers, if we focus on the average outcome we would never back up the pictures on our hard drive. Instead, we should focus on the extreme outcome that our hard drive could be wiped out, prompting us to take action and back it up.
Likewise, we should make portfolio allocation decisions knowing stock markets can fall 40% or more in a matter of days.
Extreme Market Events
During a two-week period in October 1987, the U.S. stock market fell 23%, but it fell over 40% in Australia and Hong Kong and nearly 60% in New Zealand.
In May 2010, U.S. stocks, as measured by the Dow Jones Industrial Average, fell almost 9% in a matter of minutes.
Of course, markets eventually recovered in these examples, but what would be the impact for you if the stock market fell over 40% and the recovery took decades instead of months.
For many, these extreme market outcomes would have little long-term financial impact because their portfolio balances are small and they can look forward to many more years of employment earnings that will allow them to increase their savings.
For those who are retired or approaching retirement, extreme market events could be catastrophic.
We Already Focus On The Extreme
Most people already make some financial decisions with an eye toward extreme events.
On average your house won’t burn down or be robbed, yet you carry home owners insurance.
On average, you won’t die or be incapacitated in the prime of your life, yet you buy life and disability insurance to protect your family.
We buy insurance because the future is unknown, and we want to protect ourselves against extreme outcomes.
Why wouldn’t we do the same with our investment decisions?
For most investors, there isn’t an insurance policy to protect against market losses. Instead we rely on diversification and scale our exposure to stocks based on our ability to recover from extreme negative market outcomes.
You don’t need modern portfolio theory to know that.