First off, if you are the type of person to read an article on the internet and accept it as dogma, you should probably stop here. If you need facts but can accept a certain amount of ambiguity, then please keep reading. This article will end up being much longer than I intended it to be, and I apologize for that, because there will be many more articles like this, and I will still hardly have scratched the surface. Until then, here are the 3 “most important” things about investing-
- Always invest with a long-term mindset.
- Accept that there is no such thing as the “perfect portfolio”, and that multiple kinds of risk will always be present.
- Read Howard Marks’ “The Most Important Thing”. Seriously, it is an amazing resource on investing.
- (Bonus) Past performance is not indicative of future results. Just because one asset allocation mix performed well in a high inflationary environment (late 70s and early 80s) does not mean it will do well in our current macroenvironment. Go watch The Economic Machine by Ray Dalio to learn more.
Now that those 3 (or 4) things are covered, let’s get into the meat of the article. The first issue I have to address is the index (passive) versus concentrated (active) debate. If you have been following this from the scholarly side, you know this can get heated. Which is better? Both. Index investments are not truly passive, in that they make small adjustments to the index on a daily or monthly basis, according to a set of rules designed by humans. For example, there are capitalization-weighted funds (most common), along with those weighted equally across companies, or by dividend or revenue. This is why active/passive is the wrong debate (more on this at another time). Concentrated portfolios [can] yield higher returns but are also likely more volatile. They also tend to be less correlated, which is a benefit we will look into later. As a rule of thumb, I believe that index investments should make up 50-75% of an investor’s portfolio, depending on risk tolerance and time horizon.
With the active/passive debate out of the way, let’s look at asset class allocation. Many people think that because they are not overly concentrated on one company or industry, they are properly diversified. While this may be the case within the asset class (equities), the reality is a different story. Equities tend to have a correlation coefficient of 0.6 (or higher), which means that no matter how many individual stocks you own, they will move together at least 60% of the time. In effect, a “diversified” portfolio of 1,000 companies will be no better off than one with 100 companies. This is why it is so important to diversify across asset classes (traditionally, stocks and bonds, though there are others). The chart below shows the difference between investing in a 50/50 split between equities and long-term treasuries versus 100% equities in the year 2000.
The 50/50 portfolio (portfolio 1) ended up outperforming the index (portfolio 2), 7.27% vs 5.36%, and had much less volatility (7.7% vs 15%). This is a difference of $9,000 if you invested $10k at the beginning of the period. That is kind of a big deal. This is due to asset class diversification, because each class produces returns independent of each other, allowing for greater returns with less volatility risk. This brings up the issue of lump sum vs dollar cost averaging… which is, again, more complicated that it seems on the surface. But let’s take both portfolios and invest an equal amount each month and see what happens:
We see here that both return series are essentially neck-and-neck, with the Index strategy only recently overtaking the asset allocation strategy. This strategy is known as dollar cost averaging: you can buy more of an asset when it is cheaper, and less when it is expensive, making volatility your friend rather than your enemy. If you have a stream of income you would like to set aside and invest each month, this is the way to go. Otherwise, the prior balanced strategy is better for lump sum investments. This is due to the lack of correlation between the individual asset classes, which produce returns independent of each other, such that overall returns are better over time.
At this point, I have covered active vs passive, asset class correlation, and lump sum vs dollar cost averaging. The next step is how to actually implement these concepts, which is what I will cover in the next article. Also, I barely scratched the surface with these concepts, so I will also make sure to dive in deeper to each one at some point in the future.