One Over N
Being penny wise and pound stupid is a wonderful way of saying that the focus is wrong. Whereas we should be concerned about the big picture, instead we dither away at things with far less value. In investment terms, that means we should spend much more time on the so-called strategic asset allocation, than trying to pick a particular investment. And that’s just numbers. Statistically, deciding where to put our money accounts for 90% of our investment returns, and it is easy to see why. Whether or not you allocate 20% or 50% to equities is a much bigger decision than whether to allocate 1% or 2% to Apple or Nestle.
That means we can also get it horribly wrong, and that may be the reason why so many people ask for help. The most commonly used tool of choice is optimisation, and it generally works like this: you enter the expected risk and return of each potential investment, you add portfolio constraints (like no position can be greater than 20% for instance), and the mathematical model will then give you that allocation mix with the highest expected return (given the constraints). So far so good, but what if we don’t know the expected risk and return?
Forget technical analysis, macroeconomic research or fundamental valuations to help us out here. We have more than 50 years of data proving that historical data is no indication of future performance. No one has a crystal ball. That means two things: Number one, it isn’t about beating the market and two, we need to diversify our risks. The first one is easy and all it really means is that we check our egos at the door. It is fun talking about the markets, it all sounds very plausible and it is intellectually stimulating to make logical deductions, look for insights or talk to some really smart people. But the minute you cleanse yourself of this notion that we or anybody else has been blessed with the gift of foresight, the quicker you can stop paying someone to get lucky.
Number two requires a bit of clarification. Asset class does not equal risk. In 2008, equities, commodities, corporate bonds and property all went down, even though they come from four different asset classes. To truly diversify our wealth, we need to take different risks, and that means for instance investing in strategies that make money when the market goes down, or don’t care (because they are not correlated). Only when we have truly different pots of investment risk, can we make sure that no matter what happens, something in our portfolio will always be working. And the only way to make sure that whatever we have working is meaningful, or what isn’t doesn’t kill us, is to invest equally into all areas of risk. In other words, the risk of messing up 90% of our investment returns, is far too great than trusting anyone with that decision, including ourselves. And one over n always wins.