Rethinking Investing: Common-Sense Rules for Uncommon Times

118 Comments


I first saw this video at the May 2nd, 2008 Berkshire Hathaway shareholder meeting. Prophetic and not to be missed.

I’ve learned quite a few things in the last 18 months of exploring—and experimenting with—the world of investing. This post is my first attempt to share the findings.

The lessons have come from not just reading books, but trial and error, and picking the brains of some diverse and fascinating people:

-Warren Buffett, the richest man in the world, and CFOs/financiers at Berkshire’s portfolio companies
-Chief economists at top investments banks
-Dot-commers who have turned $40,000 into $2,000,000 in stocks using massive leverage
-Conservative entrepreneurs (still self-made millionaires) with all-bond portfolios
-Money managers of the ultra-rich and ridiculously famous
-Ivy league professors who not only trade options exclusively but also bet up to $500,000 per night as no-limit hold ‘em poker players.

In all cases, excluding blog reader feedback (how could I know?), the principles I will offer are from people who have made millions in their respective investments, not armchair quarterbacks (advisers) who take a management fee from the people willing to take real risks…

Total read time for this post: 6 minutes.

I’ve lost a little money, made more money (with “risk capital,” about 28% annualized over the last three years), and preserved almost all of my money. I’m terrified of certain things, but I build my irrational decision-making and temporary stupidity into the planning.

To start, here is a snapshot of my total current asset allocation in retirement accounts. I’ll come back to this. Notice the dates:

Let’s start off with some smart observations from readers of this blog, who commented on my post where I described Warren Buffett’s answer to my question, which recentlymade it into Berkshire’s new annual report! Here it is:

“If you were 30 years old and had no dependents but a full-time job that precluded full-time investing, how would you invest your first million dollars, assuming that you can cover 18 months of expenses with other savings? Thank you in advance for being as specific as possible with asset classes and allocation percentage.”

The observations I have picked out for discussion follow, and I’ve tested most of them. Some will sound complex, but this series will reduce it all to simple conclusions anyone can use:

From Lee:

For someone so risk seeking in your personal life, I’m surprised at your risk tolerance rate of 10%. From reading your blog, it seems like you live your life experiences with a 50% risk tolerance rate.

[Tim: This is a common misconception. I actually consider myself very conservative and risk-averse in both life and investment, and my close friends can confirm this. As we'll see, the phrase "risk tolerance" is hugely problematic, but behind the scenes, I micro-test the hell out of options to determine what has the best chance of a high return-on-investment (ROI), but this isn't transparent to most observers, who assume I regularly roll the dice and hope for the best. Not true.]

Patrick Clark [Tim: if you take nothing else from this post, re-read the bolded portion a few times and memorize it, especially the last sentence]:

I am going to make a few assumptions here:

1. You are an accredited investor.
2. Your businesses will continue to run themselves and create cash flow income for you.
3. This $1 million is true risk capital.

That being said, I am a investment advisor. I create portfolios for clients in both traditional asset classes (stocks, bonds, cash, and real estate) and non-traditional asset classes (raw materials, energy, metals, and currencies). This provides a mix of investments that are uncorrelated to one another.

Without getting into specific investment vehicles, an asset allocation will look something like this:

US Equities – 24.5%
International Equities – 19.5%
Real Estate – 3%
Raw Materials – 12%
Energy – 12.5%
Metals – 12%
Currencies – 6%
Cash – 10.5%

The goal is to produce an absolute return. For my clients, I am not interested in having the following conversation, “The market was down 40% this year, Mr. Jones, but we only lost 18%. We did a great job!” No. A loss is a loss. By setting up a portfolio for absolute return, not relative returns, your chances of forwarding the ball every year is much greater.

Remember, a 50% loss requires a 100% gain to get back to even. Don’t lose.

Luca:

cash IS an asset during bear market.

From D:

Find an investment style that fits your personality, then backtest that strategy [Tim: for those of you mathematically inclined, search for "Monte Carlo simulation"] over long & varied starting/ending periods to see if you can stomach the maximum drop (”drawdown”). And stick with it…forever. No one can predict the market, you never know if you’re about to buy before a big dip.

It’s true that growth stocks outperform a helluvalot of other asset classes over the long haul.

But, someone who put all their money in the S&P500 index on 1/3/2000 lost about -50% (by October 2002) and is still losing money eight years later! Most might throw in the towel at that low point, when they should have been adding. The pain of losing is alot stronger than the hope of winning.

Superstar investor via phone:

92% of your return is determined by asset allocation, 6% my manager/stock selection, and 2% by timing.

Russ Thornton:

Once your target allocation among the chosen funds had been determined, I would rebalance back to your target allocation when any single asset class deviated 20% from it’s target. There is meaningful data supporting this rebalancing trigger. You could also rebalance with additional savings which is a much more tax efficient approach and will reduce your capital gains realization. Rebalancing forces you to buy more of the relatively less expensive asset class in a classic “buy low” discipline [Tim: versus selling the higher-priced asset].

That’s about it. Buy when you have money and only sell when you need the money, but not before.

Lee:

I like Taleb’s idea of 90% in government bonds and 10% in highly speculative stocks.

More conventionally, I’d follow a highly diversified strategy as suggested by Swensen (Yale) in his books, adjusting the bond percentage up or down as dictated by risk tolerance:

stock funds:
large blend index (S&P 500)
small value index
International index
Real estate Index
Commodities (PIMCO real return)

bonds:
TIPs
Short term treasuries

Bex:

You can have a pretty diversified portfolio, even if you only own 10 stocks.

Henrik:

So basically, for the most stable returns, invest in a set of assets that do not go up or down at the same time. That means you need international as well as US exposure, and debt (bonds/money mkt) as well as stocks. [Tim: these are also called "negatively-correlating asset classes," common in pair trading, which Buffett did quite a lot in the 1970's and 80's]

Oliver:

Your allocation should be approximately as follows:

90% TIPS
10% Call options on the S&P500

This means you’ll lose almost nothing if the market tanks but you’ll still get a lot of the return of the S&P500 on the upside.

The first lesson is: you don’t know what you think you know.

Think you can predict your risk tolerance? I bet you can’t.

Let’s try another question that will drive the point home:

Would you call yourself a racist? I bet you wouldn’t, and I bet you are.

Take the Harvard Implicit Association Test (IAT) for race as many times as you like. I’m not a betting man, but I’ll bet you come up as racist, regardless of race.

Surprising? Perhaps.

I’ve come to realize that the questions most investment advisers (and investors) ask are the wrong questions, or incomplete. Even if you have only $100 to invest, this is important to explore.

Most advice and decisions center on one question: what is your risk tolerance?

I had one wealth manager ask me this, and I answered honestly: “I have no idea.” It threw him off. I then asked him for the average of his clients’ responses. The answer:

“Most answer that they would not panic, down up to 20% in one quarter.”

My follow-up question was: when do most panic and start selling low? His answer:

“When they’re down 5% in one quarter.”

Unless you’ve lost 20% in a quarter, it’s hard—neigh, impossible—to predict your response. It’s not to dissimilar from a common boxing maxim: everyone has a plan until they get punched in the face.

False assumptions about your future decision making almost guarantees failure, so either 1) dial back your supposed “risk tolerance”, or 2) simulate the loss with smaller amounts but higher risk investments before betting the farm. I use angel investments in tech start-ups for this purpose.

It need not be $100,000—go to the horse track and make conservative bets (high-probability, low pay-out) at $25 a race until you lose $200 (FYI: here’s how I learned to bet on horses). How do you feel? That’s the starting point: accurately gauging emotional responses to gain or loss.

Your decisions, and investment future, depend on calibrating accurately.

Continued in Part II, which includes best books, redefining “investment”, and more…

Suggestions for topics in this series? Please let me know in the comments. I still consider myself a novice and this is a work-in-progress. If investment advice, please give an example from your personal experience whenever possible. Real-life anecdotes are more interesting than opinions, though opinions can be helpful.

Suggested reading:

Picking Warren Buffett’s Brain: Notes from a Novice

The Karmic Capitalist: Should I Wait Until I’m Rich to Give Back?
Lifestyle Investing: “Compound Time” Like Compound Interest?

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118 comments on “Rethinking Investing: Common-Sense Rules for Uncommon Times

  1. Tim,

    You have an interesting thread here; I didn’t have the time to read all the blog posts, but thought your questioning of the question (re: risk tolerance) was a good step. Thought I would brainstorm a bit here about returns (specific to those achieved in the capital markets):

    1. Maybe the first question is “why” are you investing?
    (A person with a net-worth of 200 million, might not need to invest…then again, maybe they do…)

    2. A follow-up might be “if for return,” – I’m not quite sure why else you might invest…but I have to leave the door open – then what is the return requirement? (I would guess that this return requirement would be framed by your goals or needs…ie. a young person with very little saved might need a significant return to get his goals whereas our 200 million net worth person might only want to match inflation)

    3. How do I get that return? This is the asset allocation and saving question… (Does it come from stocks vs. bonds, starting a business, saving more, working more? both? niether? some? all of the above?)

    4. Once you identified the return you require and how to get it, maybe the right way to proceed then is to ask the question – given my required return, can I stomach the risk involved to get that return?

    5. Maybe then, you revisit either how you get the return or what it is for?

    Just thoughts on a Sunday.

    Have a great day!

  2. Hi Tim!! how is it going? I am one of ur readers in South America from Colombia and I was looking forward to watch ur tv show in history channel but the deal is that here we have a different history channel broadcast for latin america with different shows and stuff, we might get ur show but some weeks later I guess, anyway, I was wondering if the show will be broadcast again of if there is anyplace on the net where I could watch it online. hope u can help me with that and that ur proyect with history channel keep going,
    cheers and greetings from Colombia,
    Julián.

  3. Investing entirely in fixed-income securities may make sense for a small percentage of investors, but the vast majority are better off with a mix of asset classes tailored to their needs, goals, etc. To avoid stocks merely because you don’t have an “information advantage” misses the point; by investing in a low-cost index fund you can capture the market return (historically far superior to the return on bonds), while avoiding much of the risk and intermediation costs normally associated with stocks. Furthermore, stocks offer much of their upside as capital gains, which are taxed at a substantially lower rate than the interest income generated by bonds. You are correct, though, in pointing out that there’s a bias to overvalue losses and undervalue gains, so wise investors should compensate by only checking their portfolio balances a few times a year to rebalance them, and otherwise staying well away from market news and prognostication.

    Overall, your chosen investment education program seems a little hyperactive for my tastes. I’m not sure what Warren Buffett can tell you about managing your own money that a reputable financial advisor couldn’t, especially considering that said advisor will probably know a lot more about your personal circumstances than Buffett ever will. I’d also be careful of taking market advice from investment bankers (look how that worked out for them) or “exclusive” money-managers-to-the-stars (one word: Madoff). Instead, I’d recommend reading a couple books on the subject. Burton Malkiel and John Bogle both have some excellent ones available. It’s not as sexy as talking to billionaires and celebrities, but as Ramit Sethi likes to say, there’s a world of difference between being sexy and being rich.

    One last thing: Patrick Clark’s comment about absolute returns is oddly phrased and worth examining closely. No money manager ever wants to lose their client’s money, and they would all love to produce “absolute returns” regardless of market conditions. Yet the fact remains that investing is inherently risky, and only a vanishingly tiny handful of money managers manage to consistently outperform the market averages, let alone never lose money (and it’s conceivable they’re just the lucky ones). Just because you’re “not interested” in telling your client he lost money doesn’t mean he won’t lose it, as many hedge fund investors have had the chance to learn in the last few years. Remember: risk drives return, and there is no magic bullet that will net you 8% a year after taxes and fees, or at least there isn’t anymore now that Madoff is out of business.

  4. @ Tim
    @ blog commenters

    Why invest in markets at all if you own a business to invest in? I believe that Warren Buffet says that diversification makes very little sense if you know what you are doing.

  5. Would you call yourself a racist? I bet you wouldn’t, and I bet you are.

    I took the test, and this was my result.

    “Your data suggest little to no automatic preference between European American and African American.”

    As it happens, I’m reading The Intelligent Investor right now. The original edition. Then I’ll read “Rule #1″.

  6. Tim,

    I think this is a GREAT post. Investing is a very important subject matter that is often over looked by many young professionals, especially those just starting their careers. One suggestions that I would have is to start investing in your 401k as early as you can. Most companies will match up to 3% of your 401k contributions (YES – free money from your company). You will appreciate the law of compounding when you look at the value of your retirement plan in 30 years (given the stock/bond market remains efficient).

    I understand that not all readers have the ability to contribute to a 401k because they are self-employed. Regardless of your retirement plan, START INVESTING EARLY, it will pay great dividends in the future.

    Thanks,
    Tim

  7. Money is one of the topics that I truly care about. I’m planning to invest sometime in the near future that’s why I always look up for inspirations such as Warren Buffet. I’m glad I found this post for future preferences, but right now I have to send an email because I’m running out of time. :) – Bai

    • Buffett’s a shill, a corporate crony. Say what you will about his acumen for investing, but he is a greedy hypocrite. I love how he volunteered his $5billion to help bail out the banks, meanwhile negotiating in back rooms on behalf of the very banks in which he was heavily invested to get them bailed out publicly through TARP. I imagine that just scratches the surface of his crony activity. F him.

  8. Good article, Tim.

    I took the race test and it turns out I have little to no automatic preference for either Africa American or European American. Which is a relief being as I’m mixed race.

    Thanks for the tips on investing.