A friend emailed me this excellent guide to personal finance today. If you are anything like me you will admire it for its parsimony. Email text below in italics. I have lightly edited the text to remove some personal commentary.
The personal finance game is three steps:
Step 1 = Earn Money Step 2 = Spend Less Than Money Earned Step 3 = Use The Difference To Increase Money Earned, Or To Decrease Money Spent
Think about your career. Try to advance it so that you earn more money.
Take a second job to earn more money. (Side hustle might be the best marketing trick ever. Side hustle = second job)
101 Ways To Live Like A Poor Hermit.
Pay less tax.
Using The Difference
Pay down debt. (this is the same as investing, IMO, it’s all allocating capital effectively)
OK I’m back. At an even higher level you can sacrifice a bit of resolution and summarize the personal finance game as:
Step 1: Generate Free Cash Flow
Step 2: Allocate Capital Effectively
All (and yes I seriously mean all) financial problems, for all entities other than sovereign governments issuing fiat currency, reduce down to issues with free cash flow generation and/or capital allocation. Thus, beyond the time value of money and opportunity cost, free cash flow and capital allocation are probably the most important concepts in all of finance.
Today we’re going to talk about how a lot of what is passed off as diversification does not actually provide much in the way of diversification. To illustrate this we will look at two equity allocations. The first is “diversified.” It owns all kinds of stuff. REITs. Developed market international equities. EM equities. Even ex-US small caps. Wow!
The second portfolio, meanwhile, consists solely of vanilla US large cap equity exposure.
You might think the first allocation would show meaningful differentiation versus the second in terms of compound rate of return, as well as drawdown and volatility characteristics.
It’s because correlations across these assets are high.
As you might expect, correlations are especially high across the three US equity buckets. A full 65% of the portfolio is invested across these three market segments. Just because you have exposure to a bunch of different colored slices in a pie chart does not mean you have exposure to a bunch of differentiated sources of risk and return.
Now, I’m not Jack Bogle telling you to invest only in US large cap stocks. Limiting exposure to country and sector-specific geopolitical risks or asset bubbles (see the early 2000s above) is one good reason to own a global equity portfolio. However, I AM telling you if you want to meaningfully alter the risk and return characteristics of a portfolio, tweaking weights at the margins in this kind of allocation isn’t going to do it.
Perhaps you think manager selection will do it.
Maybe if you allocate to three or four managers and leave it at that; and the managers all perform to expectations (well enough overcome any expense drag); and because of that stellar performance you don’t make significant mistakes timing your hiring and firing decisions… maybe then manager selection will move the needle for you.
But most of us don’t build portfolios concentrated enough for it to matter all that much. And most of us pick a few duds here or there. And we are terrible at timing decisions to hire and fire managers.
Much of the time we spend hemming and hawing about the minutiae of asset allocation and manager selection is therefore wasted. Should emerging market equity be a 5% or 7.5% weight in the portfolio? I don’t know. More importantly, I don’t care. It’s a 250 bps difference in weight. Just do whatever makes you (or your client) feel better.
In fact, if you’re going to add EM at a 5% max weight because some mean-variance optimization shows it marginally improving portfolio efficiency, you officially have my permission to avoid it all together. The same goes for your 2.5% allocations to managed futures and gold.
I think there are four main reasons why this state of affairs persists:
Many folks, even professionals, don’t understand how the math works. Most people I’ve shown this kind of analysis are surprised how little difference there is in the above performance characteristics.
Many folks who do understand how the math works see the truth (rightfully) as a potential threat to their job security.
Advisors and allocators sometimes worry if they don’t futz and fiddle with things at the margins or throw in some bells and whistles, clients may question what they’re paying for. (My friend Rusty Guinn refers to this as adding Chili P to the portfolio)
At the same time, advisors and allocators can’t futz and fiddle so much they look too different from their peers and the most popular equity indexes, lest impatient clients fire them and abandon their otherwise sound financial plans during a temporary run of weak performance.
All these are valid concerns from business and self-preservation and behavioral finance perspectives. But they don’t change the math.
If your goal is to harvest an equity risk premium and play the averages as cheaply and tax efficiently as possible… then do that.
If you want to concentrate your bets in hopes of generating massive gains and you’re comfortable with the idiosyncratic risk that entails… then do that.
If you want to employ a barbell or core-satellite structure to balance cheap beta exposure with a selection of (hopefully) substantial, alpha generative bets… then do that.
Because if you waver, and you combine this and that and the other philosophy because you’re simultaneously afraid of looking too different and not differentiated enough… then you’re going to end up with something like the world’s most expensive index fund.
My latest note for Epsilon Theory is a golf lesson we can apply to our portfolios.
The most grievous portfolio construction issues I see inevitably seem to center on basic issues of strategy and commitment. Particularly around whether a portfolio should be built to seek alpha or simply harvest beta(s).
You don’t have to shape your shots every which way and put crazy backspin on the ball to break 90 in golf. Likewise, not every portfolio needs to, or even should, strive for alpha generation.
There are few things more destructive (or ridiculous) you can witness on a golf course than a 20 handicap trying to play like a 5 handicap. And it’s the same with portfolios. For example, burying a highly concentrated, high conviction manager in a 25 manager portfolio at a 4% weight. Or adding a low volatility, market neutral strategy to an otherwise high volatility equity allocation at a 2% weight.