If you’re one of the millions of people launching into the gift-buying spree this holiday season, then there’s a good chance you’re inundated with numbers right now. From
performance statistics and customer ratings to price points and discount percentages, smart shoppers are in a constant search for the best bang for the buck. Even if you’re not the type of impulse shopper that particularly enjoys the experience of browsing the aisles for just the right gift, experienced marketing professionals have learned that maximization of value is a powerful motivator that can pull even the strongest introverts into crowded stores against their better judgement. Why do you think they spend so much money on Black Friday ads touting record-breaking deals?
After a lifetime of this type of shopping conditioning, it’s no wonder that this same maximization mindset might bleed into other decisions as well. Like, for example, what asset allocation you might choose for your life savings. So the same highly intelligent shoppers often create very similar lists of investing options sorted by the most common performance metric available — average return. Just like how you might seek the best resolution for a new computer monitor or the highest customer rating for a new toy, you surely want the highest average return for your hard-earned savings. Right?
Unfortunately it’s not that simple. Contrary to your data-driven instincts, averages lie. So take a break from your holiday shopping, find a comfortable chair with your favorite drink, and let’s talk about how averages distort our thinking.
Whether you prefer jump scares, bloody zombies, or simply a cute dog in a ghost costume, Halloween is all about kicking back and having a little fun with fear. But while watching a good horror flick with a bag of candy may indeed be a good time, the adrenaline may not necessarily wear off so quickly if you’ve been watching the increasing volatility of the markets lately.
Wanna see something really scary?
For anyone not paying attention to the news, the Mega Millions lottery in the United States just topped a billion dollars and is quickly rising even higher. You read that right — a Billion with a B. For the meager price of a $2 ticket, some lucky person will eventually break their way onto the list of the world’s wealthiest people. Talk about an impressive return on investment! Of course the odds of actually winning that money are beyond astronomical, and one in 300 million is a difficult number to even comprehend.
Generating accurate and intuitive charts to help you navigate the professional asset allocation landscape is pretty darned rewarding, and I take a lot of pride in contributing to everyday asset allocation discussions in my own data-driven way. I also spend a lot of time reading those same discussions online, as not only does it help inspire new ideas but it also helps me understand what drives people. Everyone’s motivations are different, and when you put your life savings on the line the stakes are also quite high so people tend to really tell you what they think.
While that variety of strong opinions makes the financial blogosphere particularly difficult to navigate for new investors, I personally find the abundance of different perspectives a fascinating design challenge. That’s because beyond simply crunching numbers like a good engineer, I’m also a designer at heart and love solving complex problems and bringing new ideas to the table. The Golden Butterfly is one such example, but I don’t believe there’s one perfect way to invest and my problem-solving circuits are always scanning for new ideas to help people find an asset allocation that resonates. So in that spirit, today I want to talk about a new portfolio idea that based on all I’ve read I think a lot of people may find helpful.
If you’ve been paying any attention at all to financial news this week, you’ve probably heard about the large 19% drop that Facebook experienced on Thursday. Facebook is the fourth largest company in the US by market cap — behind only Apple, Microsoft, and Amazon — and the total loss amounts to a staggering $120 billion wiped out. That’s easily the largest single day loss by one company in recent stock market history, and if you’re personally holding a lot of Facebook stock you’re probably not a happy camper.
But let’s say you’re more the index investor type than the individual stock picker. Should you be worried?
Every once in a while life takes the opportunity to throw you a curveball and dump some good financial fortune in your lap. Whether it’s a bonus at work, a family inheritance, or a lucky night in Vegas, an influx of cash is generally a welcome sight. But because of the rarity of these life events, most people are usually caught a bit off guard and are unprepared for what to do next. Set aside for a moment the fantasies we all have about crazy things we might do if we won the mega lottery — what exactly is one supposed to responsibly do with a financial windfall?
Yale University recently released their 2017 annual report for the Yale Endowment, and while normally this would pass without much notice they appear to have made a few waves by continuing an ongoing feud with Warren Buffett. In his 2016 investor letter, Buffett criticized how university endowments pursue market-beating returns through active management and suggested they might be better off investing in index funds instead. Of course the CEO of Berkshire Hathaway follows none of that advice himself, but he has consistently said that most investors including his own wife would be better off with a low-fee S&P500 index fund rather than paying expensive active managers so it’s certainly not out of character. In any case, Yale appears to have taken that a little personally and they dedicated an entire section in their annual report to dispute his claim and promote their own success.
To support their belief in active management, Yale provides data that proves their managers have exceeded stock market returns for the past two decades. For example, over the past 20 years they posted an average return of 12.1% versus 7.5% for the total US stock market which gives them confidence to say they “crush the returns produced by US stocks”. Ending with a flourish, they conclude that “not only has the model worked for the past two decades, it will work for decades to come.”
That’s bold. And it caused a bit of a tizzy in the financial blogosphere with several stories on the topic. So are they right?
Asset allocation is a obviously passion of mine, and I’m always excited when I find a new metric to tinker with. These new ideas are not only interesting in their own right, but they also allow me to go back and refine some older tools to make them even better. And it’s hard to think of a more appropriate place to start than one of my personal favorites — the Portfolio Finder.
I don’t think many people will be surprised to learn that I’m not a fan of using single averages to describe portfolio returns or over-simplified metrics like standard deviation to measure risk. Both of those numbers obscure so much information that they often lead to disappointing investing decisions and give backtesting a bad name. I personally have a much more nuanced perspective that embraces the idea of unpredictability in financial planning while keeping things in terms that make sense in the real world, although I’m well aware that uncertainty is a very difficult concept to understand and an even more difficult one to apply.
So sometimes even the simplest questions can trip me up. For example:
What expected return would you use for the Three-Fund Portfolio for your own financial planning?
With the stock market recently dropping more than 10% in a short amount of time, I’ve noticed a lot of panic in financial circles. Beyond the fairly steep short-term loss there’s also the fear that a much more painful long-term correction may finally be starting, and stock market investors are understandably on edge.
Do you worry that your life savings are about to catch fire and burn to the ground? Setting aside what is causing the drop, whether it portends a major correction, or even whether you should be all that concerned about it in the long run, I’d like to focus for a moment on your very real anxiety and what you can absolutely do about it.
I’m personally not worried in the slightest, and it’s not because I’m some sort of investing robot who never gets upset. It’s because I would not have known that there’s such a major stock correction from looking at my own account balances, as a panic-inducing drop just isn’t there. While comparing relative portfolio performances over just a few weeks is pretty pointless, in this case it’s definitely not a matter of luck but of very deliberate structural portfolio planning. When I invested my money, I took the time to build firewalls.