Over the past 25 issues, there’s been no shortage of discussion around different wealth building strategies.
Want to know how to find guaranteed double-digit returns? Easy. Pay off high interest debt.
Want to know how to build wealth by paying fewer taxes? Understanding how to use debt the right way is one of the simplest ways to do this.
Want to know where EXACTLY to invest your money for the best possible returns with the lowest possible risk?
For that, we need to understand one of the most important concepts in finance – asset allocation.
That’s the topic of today’s issue of Private Capital Insider.
-Jake Hoffberg
P.S. Last week, I revealed some of the details about my current book-in-progress…
The Generational Wealth Code: Exposing the Secret Wealth Building Strategies Used by Financial Insiders and Elites to Get Rich in Record Time
A huge thank you to all the people who emailed in and left comments on the poll.
Here’s some of the messages that warmed my heart, and continue to serve as a reminder that the work I’m doing matters.
P.P.S Looking for back issues of Private Capital Insider?
What REALLY drives investment returns: Investment Policy vs Investment Strategy
According to the often cited study Determinants of Portfolio Performance by Brinson, Hood, and Beebower and published in the Financial Analyst Journal in 1986:
A plan’s benchmark return is a consequence of the investment policy adopted by the plan sponsor.
Investment policy identifies the long-term asset allocation plan (included asset classes and normal weights) selected to control the overall risk and meet the fund objectives.
In short, policy identifies the entire plan’s normal portfolio.
Our framework clearly differentiates between the effects of investment policy and investment strategy.
Investment strategy is shown to be composed of timing, security (or manager) selection, and the effects of a cross-product term.
The results are striking.
Naturally, the total plan performance explains 100% of itself (Quadrant IV). But the investment policy return in Quadrant I (normal weights and market index returns) explained on average fully 93.6% of the total variation of the actual plan return.
Said another way, ~90% of a portfolio’s return profile is determined by asset allocation (“where” you buy), with the remaining ~10% attributed to security selection (“what” you buy) and market timing (“when” you buy).
However, most people think it’s the opposite – security selection and market timing is the key to outsized returns.
In 1991, the authors would publish a follow-up paper, Determinants of Portfolio Performance II: An Update, that would confirm their original conclusions, and they expand upon saying,
Data from 82 large pension plans over 1977-87 period indicate that investment policy explained, on average, 91.5% of the variation in quarterly total plan returns.
In addition, this article provides an expanded permanence attribution framework that accounts, not only for security selection and active asset allocation, but also for changes in portfolio risk characteristics attributable to risk positioning within individual asset classes.
Neither this article nor its predecessor attempts to evaluate the efficacy of investment policies. Rather, the concentration is on the overwhelming impact of policy – however established – and the incremental effect of active investment strategies.
Asset allocation policy involves the establishment of normal asset class weights and is an integral part of investment policy.
Active asset allocation is the process of managing asset class weights relative to the normal weights over time; its aim is to enhance the managed portfolio’s risk/return tradeoff.
This distinction is material to understanding the importance of investment policy relative to active management.
Said another way, if you’re planning on doing any kind of active management of any portfolio, much less the one you’re trying to turn into Generational Wealth…
To be fair, there is a rather infamous rebuke to the study’s findings called “The Asset Allocation Hoax” – it argues that the original study doesn’t take into account costs, misrepresents variance vs raw return, and the author overall disagrees with fixed-weight asset allocation (fixed forever over the time period), in favor of dynamic asset allocation (which can change).
However, this mental shift from “stock picking” to “portfolio building” is the difference between Insiders and Outsiders in the financial markets.
And if you’re truly looking for a way to “Get Rich Without Getting Lucky”…
It’s critical to shift your thinking towards a portfolio model (of which you then select securities inside of), instead of chasing after whatever is “hot” right now.
We’ll get into the actual nitty gritty of the different asset allocation models wealthy people invest with…
But first, let’s talk about one of the most widely misunderstood financial theories that keeps you stuck on the Outside.
Modern Portfolio Theory and the Myth of Efficient Markets
In 1952, Harry Markowitz published one of the most important theories in modern day finance…
So important that for it, he later won the 1990 Alfred Nobel Memorial Prize in Economic Sciences.
It’s called Modern Portfolio Theory… and is considered by some to be the bedrock of modern finance.
But some studies suggest this widely accepted theory is actually wrong (or at least not entirely right).
And if you – or your financial advisor – are building a portfolio based on this potentially flawed theory, your money could be in more danger than you think.
At its heart, Markowitz’s theory is centered around a core assumption…
There is a rule which implies both that the investor should diversify and that he should maximize expected return.
The rule states that the investor does (or should) diversify his funds among all those securities which give maximum expected return.
However…
The portfolio with maximum expected return is not necessarily the one with minimum variance.
There is a rate at which the investor can gain expected return by taking on variance, or reduce variance, by giving up expected return.
Put another way, it is possible for an investor to build a diversified portfolio of multiple assets or investments that will maximize expected returns while limiting variance (i.e., “risk”).
The math equation winds up being “Expected Returns (E) minus Variance (V)”
With this simple equation, we get a chart of all possible outcomes (which winds up being a circle).
The E-V rule states that the investor may want to select one of those portfolios which give rise to the (E, V) combinations indicated as efficient in the figure; i.e., those with minimum V for given E or more and maximum E for given V or less.
A portfolio is “efficient” if it has the best possible expected return for a given level of risk, or likewise, the lowest possible risk for a given level of return (which is represented by the outer line of the circle).
So, how do you build a portfolio that seeks to optimize Expected Return vs Variance?
By investing in uncorrelated assets – which is a fancy way of saying “invest in stuff that won’t all go down (or up) at the same time.”
Why? Because uncorrelated assets – in theory – should reduce large swings in the portfolio value.
This is one of the reasons why investors like to own physical assets like real estate, precious metals, and commodities, versus purely owning “paper assets” like stocks and bonds.
While I certainly have no disagreement with the idea behind diversification, there is a major weakness when it comes to properly pricing in risk.
Black Swans, Tail Risk, and Barbell Investing
The term “Black Swan” – an unpredictable event that is beyond what is normally expected of a situation, and has potentially severe consequences – was popularized by Nassim Nicholas Taleb in his 2008 book, The Black Swan: The Impact of the Highly Improbable
In his own words…
What we call here a Black Swan (and capitalize it) is an event with the following three attributes.
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
Second, it carries an extreme ‘impact’.
Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.
Or put another way, events beyond peoples’ predictions create massive – and often long-term – impacts on history…
Which creates a huge problem when you’re trying to anticipate things like Expected Returns and Variance.
The solution?
Taleb’s thesis is simple: If it’s impossible to predict the unpredictable, it’s impossible to accurately account for risk…
And for an investor who can spot opportunities where risk isn’t properly priced in, they can stand to make a fortune.
A feat Taleb famously did as an options trader when he allegedly earned “tens of millions of dollars” from the stock-market crash on October 19, 1987; Black Monday.
How’d he do it? By taking advantage of the gap between the “real risk” and the “expected risk,” known as “Fat Tails.”
Essentially, the “fat tails” model describes how a typical bell curve – which has even distribution and “thin tails” at the edges – is wrong.
Why? Because the universe runs on Power Laws… not bell curves!
Unlike bell curves, Power Laws (heavily-tailed, non-normal distributions) tell us that extreme events are massively more likely than we care to predict.
According to a 2014 whitepaper by NZS Capital called “Complexity Investing”…
Conventional market models and modern portfolio theory assume that events cluster around a mean (bell curve); but, in reality financial markets follow the 80/20 rule (power law).
Skipping past the math, the key insight we gain from power law modeling is: large changes/events are far more likely to occur than what ‘normal’ distribution curves would lead us to believe. In fact, they’re not that uncommon.
Which is why, for those of us who wonder why we live through so many three-standard deviation events, power laws make intuitive sense.
One might even argue that current risk models have made things worse, which takes us back to the future: because we can’t accurately predict the future, risk often turns out to be more random and extreme than our models predict.
Perhaps we should spend less time trying to build a portfolio that attempts to pin down the future within a narrow range of outcomes and neatly quantified risk (which is really tough unless you have access to a tricked-out DeLorean and a bit of Plutonium).
Instead, perhaps we should think more about allocating capital in a way that reflects how companies and portfolios thrive in a complex environment.
So, the next time you ask someone, “should I invest in XYZ,” the reason why it’s so hard to answer is because it’s entirely relative to the rest of your portfolio.
Which brings us to a perhaps more important question.
If the financial models being used by a majority of investment professionals are, in fact, wrong because they assume bell curve distribution…
How does an investor think about building a portfolio designed to take advantage of these Black Swan events?
According to Taleb…
If you know that you are vulnerable to prediction errors, and accept that most risk measures are flawed, then [one potential] strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative.
This strategy – known as Barbell Investing – requires the investor to essentially cut out the middle section of the portfolio, and weight it heavily at the extremes.
This kind of portfolio might look like 90% allocation in cash, bonds, and gold, and the remaining 10% on highly speculative opportunities.
In case you’re wondering, I am hardcore barbelled as the vast majority of my networth is some combination of cash and equity in closely held businesses.
I’m also 36 years old, debt free, no kids, I keep my expenses low, and I have an absurd risk tolerance.
PLUS! As the owner/operator of said closely held businesses, I have a high degree of control over the outcomes (versus actively trading options or something).
This is my “Redwood” strategy. Compared to the bush that diversifies early, the redwood is hyper focused and concentrated on growth for as long as possible before it diversifies!
However, in my experience, Barbell Investing is way too emotionally stressful for most people to do for any length of time.
It requires a tremendous amount of discipline to essentially lose money on a regular basis, with the assumption that eventually, a “big one” will pay off and cover all your losses (and then some).
That’s why I generally find it easier for people to take a more balanced approach to their asset allocation.
How Insiders and Elites Build Portfolios
As a general consideration, we all want to get the highest returns possible, with the least amount of risk.
But here’s the problem with risk. It’s notoriously hard to quantify and price correctly. That’s why you’ll often hear financial professionals talk about something called “non-correlated risk.”
If two assets are considered to be non-correlated, the price movement of one asset has no effect on the price movement of the other asset.
Said another way, we don’t want all of our assets to be exposed to identical risk factors; if the “risk” actually happens, it impacts everything.
If you’re an “Insider” to the capital markets, you’ve got access to a wide variety of financial products and trading strategies that seek to offer this non-correlated risk…
But when you’re an “Outsider” to capital markets, chances are you wind up with an “off the rack” portfolio that looks something like this:
The Outsider Portfolio
If you’re in your older years, you might be in the classic “60% equities, 40% bonds” (called “60/40”) portfolio.
According to Vanguard: The goal of the 60/40 portfolio is to achieve long-term annualized returns of roughly 7%.
But here’s the problem. Even if those returns were guaranteed – which they aren’t – it takes ~10 years to double your portfolio at a 7% compound annual growth rate (CAGR).
If you want to 3x your portfolio over the next 10 years, you need a ~12% CAGR; 5x in 10 years requires ~17.5% CAGR; 10x in 10 requires ~29% CAGR.
Now, depending on your risk tolerance and time horizon, you might be comfortable moving into a more aggressive portfolio model and taking on more risk…
But here’s the perennial problem with concentrating all of your assets into a model portfolio that ONLY has publicly traded securities:
There’s essentially no meaningful diversification from stock-market risk… which is the whole point of diversification in the first place.
That’s why Private Capital Insiders (like family offices, high net worth individuals, and institutions), have portfolio allocations that look something like this:
The Insider Portfolio
In this model, the traditional 60/40 is collapsed into a 21/7 (or ~30% of the total portfolio allocation)…
But, more than half of the portfolio is invested in Private Equity and Real Estate.
Insiders don’t invest this way by mistake. They do it because the historical evidence suggests adding alternative investments provides persistent outperformance.
This is great news if you’re an investor like the Yale Endowment Fund, with billions of dollars in AUM (Assets Under Management) and a multi-decade time horizon. Over the past 30 years, Yale’s investments have returned an unparalleled 13.1% per year (or a whopping 40x multiple).
But if you’re a normal, everyday investor with less than a $10m net worth, it’s significantly harder to construct a portfolio the way institutions do.
Up until recently, the only realistic option for retail investors to add Real Estate and Private Equity to their portfolio is to become a landlord or a business owner.
This is starting to change as asset managers – like Blackstone – started launching retail-focused alternative investment products, and the JOBS Act gained greater adoption in the capital markets.
Final Thoughts: Investing in Inefficient Markets is Key to Outsized Returns
Whether or not you believe in Modern Portfolio Theory, and the efficient markets hypothesis…
If you can’t beat an efficient market, this means you CAN beat an inefficient market.
As a small-balance retail investor, I have no confidence in my ability to exploit any form of inefficiency in the public markets.
But, because there are entirely legal ways to gain an information advantage over other investors in the private markets…
It only makes sense why there’s an ability to earn outsized returns, compared to public-market peers.
