The biggest misconception and the cost of having a subconscious asset allocation vs explicit asset allocation
If I had to explain the investing process in two sentences, the first most important part is to choose what you want in life and why. The second part is choosing the way to get there. We already discussed that debt can be used to accomplish bigger goals such as buying a house. However, for many of our other goals such as children’s education, retirement, trip around the world, we can use a different strategy.
In most cases, people do not even think about their goals. The process usually begins with hearing about a market instrument and allocating one’s entire net worth to this asset class. For instance, in 2017, a lot of people were invested only in the cryptocurrencies sector and had no other assets such as stocks not to mention gold, silver, bonds or any of the other instruments that exist in more traditional portfolios. Those people had a “subconscious” asset allocation which was represented by 100% cryptocurrency exposure. Some even borrowed to increase their holdings, which meant that they had more than 100% of their income into the asset class. Most of those “investors” did not realize they were speculators (they speculated on the price of Bitcoin and other digital currencies going up or down). By now, 90% of them are out of the market at a minus and if you ask them about cryptocurrencies they would say something like “don’t talk to me about these Ponzi schemes”. The essence of this lesson is that when people have no clear goal, they have no real target of where to sell (no clear intention), as a result they usually hold forever (unclear action). If the goal is unclear, then the allocation of people’s money has an implicit goal which is to make money. Because this goal is implicit, people saw accounts grow from 10-20k to 100k, but then drop down to 5-2k because making 500-1000% was not enough for those who had no clear plan. In 2020, the same is going on with NASDAQ stocks and those who own 100% of these (or even worse, only own call options as it has become so popular today) could end up losing a lot and not returning to the market.
The key takeaway is that one can achieve much better returns and accomplish his or her life goals at the same time. However, this requires a person to have clear life goals and the asset allocation (the choice of how to allocate the money) should reflect this. If you don’t know how to define your life goals, that’s fine, you could use our WAVERIDERSCM goal sheet to define Wantable, Attainable, Value-reletable, expressable, relevant, improvement-oriented, duration-bound, energizing, re-workable, specific, controllable ,measurable goals. These typos are on purpose as they represent unique and specific meanings which we have attributed to those words.
Designing the Optimal Asset Allocations conventional wisdom and WaveRidersCM approach comparison
The first step of designing an optimal asset allocation is to understand it does not begin with the market but with us. It begins with the clear definition of our 1) goal and the why of the goal (is it a life goal or something very desirable), 2) risk tolerance and appetite, and 3) the duration we have allowed ourselves for achieving this goal and 4) knowledge of psychological biases and misbehaviors which prevents most investors from accomplishing positive returns, let alone beating the market. As it can be seen, the first 3 decisions of choosing the optimal asset allocation have nothing to do with the market, its instruments and how many percentages of what asset. Rather, the instruments, percentages of asset classes and market selection should represent the outcome of clarifying one’s goals, their time duration and one’s risk capacity, and knowledge about those traits in our human nature which are very useful in other situations (like herding) but when it comes to the market they could devastate us and our wealth.
Only after one has clarified the goal, and its duration, risk capacity, knowledge level of misbehaviors, only then different mixes of instruments (stocks, cryptocurrencies, gold and other commodities, bonds, FOREX) can be used to accomplish the goal.
The key thing which usually separates those who win in the market from those who are always on the losing side it the asset allocation. Most professional investors know they cannot know how every trend would move and there could be many short-term surprises. Therefore, they choose to have asset allocations which are diversified in nature (across countries, industries, industry types (cyclical vs counter cyclical), sizes of companies, and so on). In this way, they try to intentionally have some positions which are winning and some positions which are losing. The positions which are currently losing are expected to perform well when the positions which are currently winning start losing. In this way, having a return on a daily, weekly, yearly basis is not contingent on one asset and it rarely causes “misbehaviors” such as buying “high (e.g. Bitcoin at 16,000) and selling low (e.g. Bitcoin at 3,200-3,400)”. In the cryptocurrencies craze, many people lost their shirts because they could not handle the embarrassment that their losses brought (and so to save more embarrassment they made them permanent), which in my view is more embarrassing as I do believe the asset class has value (but it should be about 5-15% of one’s allocation).
In short, having cryptocurrencies as part of a bigger asset allocation provided many benefits to those who realized it is just another class which can be used to get us closer to our goals. For those who had their entire net worth in the asset class, this became a lesson of why they should not invest. They most probably didn’t even learn the proper lesson as what they did was speculating and not investing. Investing is about choosing the optimal strategy (reflected in our asset allocation) to accomplish our life goals. Buying Bitcoin for $1000 to make some money is not a clear goal and those who have it, equitably did not make any money as they did not respect the rules of the market and the investment process.
Another example of wrong asset allocation of unclear goals are people like myself back in 2013. I read all the books on investing in ETFs with all their theories about how no one can beat the market and so on. I chose a mix of ETFs (an asset allocation) which was also subconscious. It had to do with the reasons of the market (such as risk and return), which American authors wrote about but in time, I realized this asset allocation makes no sense to me because I am neither American nor I have IRA/401k or any other tax-efficient vehicle which made those suitable for me. I will not go as far as to say that those authors convinced me to the wrong thing, I would say that the asset allocation was wrong as it had no relation to my personal situation, my goals, risk capacity or duration. The recommendation is to hold funds forever as this is the best thing to do. I highly disagree that this would be the optimal decision for every person and every situation. While it’s a nice story, by now most of us have learnt that one size does not fit all.
I summarize the key takeaways of such books and their wisdom on creating an optimal asset allocation:
1. The long-term (expected) returns and risks of many kinds of stocks and bonds are well known. Unfortunately, over periods of up to 10 or 20 years, actual returns may be significantly higher or lower than the expected return. The amount of “scatter” from the average value is known as the standard deviation (SD) and is virtually synonymous with risk.
2. Effective portfolio diversification can increase return while reducing risk. Achieving maximal benefit from effective diversification requires periodic rebalancing of portfolio composition back to the target, or “policy” composition. This is often emotionally difficult to do, as it almost always involves moving against market sentiment.
3. Whether you like it or not, you are a money manager. Asset allocation accounts for most of the difference in performance among money managers. Arriving at an effective asset allocation is both critically important and not that hard to do. Long-term success in individual security selection and market timing is difficult to impossible; fortunately, they are nearly irrelevant.
4. Since the future cannot be predicted, it is impossible to specify in advance what the best asset allocation will be. Rather, our job is to find an allocation that will do reasonably well under a wide range of circumstances.
5. Sticking by your target asset allocation through thick and thin is much more important than picking the right asset allocation.
I agree with all those points which is why I have put them here as well. However, from here onward, most authors start looking at the market and the performance of stocks and bonds as the key instruments to accomplish almost any goal. They do mention that depending on time, there could be different instruments but if one is a long term investor, the advice is to have over 70% in stocks and let the market do its thing. The main reason for having those is that adding asset “asset classes” is expected to produce diminishing returns after adding 3-4 or more asset classes (i.e. that the asset classes are correlated and the diversification would not work).
To me this is to say the least debatable. For instance, authors give real estate to be negatively correlated to stocks. In reality, real estate is positively correlated to economic activity and the use of more or less commercial estate signals whether the economy is strengthening or weakening. In 2002, when NASDAQ stocks fell and real estate went up, this was not because real estate was negatively correlated to NASDAQ but because real estate dropped in price (and completed its correction) much before stocks. Therefore, adding real estate and stocks could actually be redundant (even though this one of the main recommendations by PhDs in the sector).
I will not continue to compare what PhDs on passive funds which they are on the boards of directors of recommend with my own view of asset allocation. To me the industry works in the model of – 1) we have a fund and 2) we sell it to our client and convince him he cannot do better. This could be true, but to me the right model would be 1) clarifying the goal, 2) realizing how far close I am to the goal (using the WAVERIDERSCM GOAL CALCULATOR), 3) realizing how much return I would need, 4) seeing if my risk tolerance capacity match my goal, 5) adjusting if needed, and 6) evaluating the possible mixes which can produce this return. Once the internal and external factors are matched, only then the optimal portfolio for a specific person can be created. This cannot be done using only external (market-related factors). The optimal asset allocation also cannot be specific if one is trying to think about risk tolerance WITHOUT the context of the goal. For many goals, our set-up is that the risk of not accomplishing it is bigger than the risk of failing to accomplish it. This cannot be thought of properly if the goal is unclear. Alternatively, if the person has biases and misbehaviors (e.g. thinking I can lose 1000 to try to make 3000, but I can’t lose because I am too smart) can actually lead to the worst asset allocation relative to the goal because it could be that the 1,000 was enough to say go on a trip.