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?

Posted on: October 21, 2008.

Watch The Tim Ferriss Experiment, the new #1-rated TV show with "the world's best human guinea pig" (Newsweek), Tim Ferriss. It's Mythbusters meets Jackass. Shot and edited by the Emmy-award winning team behind Anthony Bourdain's No Reservations and Parts Unknown. Here's the trailer.

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

  1. Great post and I love your work. One small thing — I think there is a Harvard study that shows that 94% of all investment returns are determined by asset allocation (not 92% as mentioned above). This is a small difference and I’m not here to focus on that. Rather I want people to focus on how high this number is. It means ALMOST ALL of your returns will be derived by that single choice. So focus your time on make a good decision about that and far far far less time picking stocks or funds or money managers. Good luck to all and Tim, please keep up the great work!

    Like

  2. Tim,
    First of all, I cannot agree with you more on this post… I’m glad to see you’re not going down the road 99% of North Americans (yes I’m Canadian) are going down with: that is carrying medium and high risk funds in their portfolio on top of paying exorbitant managing fees.
    If you haven’t yet read it, Daniel R Solin’s book called “the smartest investment book you” ever read is the only book one needs to read about investing. Actually, I take that back, the only thing one needs to see is the diagram he put on page 12 which basically outlines that over the last 30 years, we’ve noticed that low risk funds give you virtually the same return as a high risk fund with out the risk of loosing money!
    Keep up the great work Tim and I’ll keep reading.

    Like

  3. My one critique of this post is the same that I have of nearly all investment advice: it says plenty about what to invest in, but nothing about the actual act of investing. For total beginners, it is far from obvious just how to go about making investments. One of the things I loved about 4HWW compared to other “business” books was how specific it was about taking action, going so far as to recommend specific useful companies/services and provide contact information. Advice like this is great, but it’s not impossible to find; meanwhile, searching for those specific actions to take usually just leaves one lost in a sea of advertisements for various brokers. I would love to see some investment advice that takes the 4HWW route: specific steps to begin investing in addition to suggestions on investment choices.

    Like

  4. My epiphany is that contrary to popular belief, Tim is highly risk-averse and micro-tests everything before trying it out. Throughout the 4HWW there were continual hints that this was the case; an adwords campaign to decide on the 4HWW’s title, praising Ed Byrd for releasing a pamphlet before releasing his product etc. It was easy to get swept along thinking that creating a successful business could be done by instinct and fearlessness. Success in anything takes, at the very least, time and hard work made obvious by superstar investor’s statement that ROI is 92% dependent on asset allocation. The investing formula seems pretty straightforward; diversify as much as possible and play the market cautiously. Aiming for a long term gain that comes eventually will leave you in a much stronger position than looking for a short term gain that could never come. Since we could argue all day about where and how to diversify; invest in something that you find relatively interesting, you will likely already be well informed about its performance.

    @Tom VanAntwerp I couldn’t agree more, I have read plenty about investing but nobody has made it especially clear about how to start playing the game or investing a few hundred. I’d love to know more if anyone could make any suggestions.

    @Morgan Coudray Thanks for suggesting Solin’s book, I’ll have to check it out.

    Like

  5. – More important than anything else: diversify, diversify, diversify (preferably in non- or low-correlated asset classes – warning: correlation during normal times is different from correlation during market crashes)
    – Only invest in stocks (and other risky stuff) if your investment-horizon is long enough to outwait the market if things go wrong (ie only invest money in it that you won’t need during in the first 5-10 years)
    – “Maximum tolerable loss x 2 = Maximum equity allocation” (at least according to Adrian Nenu from bogleheads.org)
    – Low cost no-load index funds are generally a good idea (they don’t underperform the market)
    – Rebalance when an asset class deviates 20% or more from its initial allocation
    – There are interesting non-mainstream strategies out there may or may not be good ideas: Harry Browne’s permanent portfolio (book: Fail-Safe Investing), misc momentum-based strategies (example: http://www.FundX.com), etc.
    (disclaimer: I’m inexperienced. I’m still 100% cash and trying to put a strategy for myself together. Thanks for this interesting post!)

    Like

  6. Tim,

    I remember you posting previously about the horse races and that during your experience you got it down to winning every race? (correct me if I’m wrong, my memory isn’t exactly the best)

    Anyways, I would be very interested in learning about your experiences with betting, I’d love to see the way that you approached it, no doubt there’s something to be learnt there.

    Cheers,

    Like

  7. I still think the best personal money management book ever written is a series of stories written from the 1920s to 1940s by George S. Clason, compiled into a single book, and published as “The Richest Man in Babylon”. You can pick it up at any bookstore for $7.

    Like

  8. I just have to say Tim you are one dam inspiring guy, I love the fact that you dont just blindly follow the advice of anyone but you get to the people that count and implement solid action plans. I would say that this would be absolutley crucial in the current market and if you have no idea in investing, get one!

    Rich

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  9. Tim,

    This post is very interesting. I love the video –> “Shall I jump out of the window??” Ha.

    I am a novice as well, but have been interested in learning more about the details of asset allocation. I am currently working with an advisor, who I do trust and know very well, but moving forward, I want to be more involved with and knowledgeable regarding the reasons behind what % goes where and why.

    When you take a step back, it is comical to think how obvious some things are (i.e. buy, don’t sell, when the market dips), but it seems only a minority follow this practice. The balance between international vs US stocks also makes complete sense.

    Looking forward to part 2.

    Sheila

    Like

  10. Hi Tim,

    This is a topic that I am very passionate about … trading and investing.

    I’ve had my ups and downs, my bruises and my celebrations – and, through all this, I’ve survived (and thrived) as an independent stock trader.

    Similar to yourself, I, too, have had the pleasure of meeting Warren Buffet and, though most people would never hear of him, Ed Seykota (who, by the way, may not be the richest man in the world – but may be the most successful trader in history earning 250,000% in just over a decade).

    The first thing you must realize is that all trading and investment activities are a matter of probabilities. No forumula to date has been able to produce 100% accuracy rate – there are profits and there are losses.

    People often ask me: “What’s the difference between trading and gambling?”

    The answer is that people who are gambling with their trading either do not know their odds or are investing with the odds against them.

    People who are not gambling know their odds.

    I recommend approaching trading with a question: Do I want to trade like a casino or a gambler? Both have notable stories of making big money – but who makes the most?

    If you choose to trade like a casino – then you must know and understand your odds.

    There’s so much more to share but … only so much time.

    Be smart. Know your odds and, though you may not “win every hand” – if you’re trading with the odds in your favor, you can reasonably expect to be profitable over the long term.

    Good luck,
    Charlie

    Like

  11. Tim,
    Another great article. I think the Havard race test is a joke though. I took it once and tried to go as fast as possible. Here’s what I scored “Your data suggest a moderate automatic preference for African American compared to European American.” I’m white. So this would mean I favor African Amercians and am racist to European Americans like myself subconsciously. I believe this test is setup to show show a preference to white people. First of all its just putting you in a pattern of matching images and words to a certain side. Then it further stacks the deck by putting the good on the same side as the European American in the second round. Next it stacks the deck even further by putting Good and European together first, so you automatically associate them together when the swap them for the next round. I still scored opposite of what they were obviously setting me up for because I was going fast and they would put so many consecutive left or right keys in a row then throw the curve and I would hit the same key I had been hitting which just probably happened to pair a good word with African Americans or a bad word with European Americans.

    Back to the main topic. Yeah, I’ve taken a big hit this year. I’ll watch the video at home when I have more time. I do like the bold parts. I’ll have to think about it and talk with my planner some more once I read the rest of he series.

    Joe

    Like

  12. Tim, this is a great start to your series – especially in light of current events – but I’m definitely looking forward to you getting into the “philosophy” of your investment strategies a bit more.

    For example, a member of the New Rich isn’t all that well served by traditional retirement vehicles. I can only stick $4000 a year in a Roth IRA and any other retirement investments penalizes the hell out of me for early withdrawal of my capital. How do I deal with that as an investor who plans to take up to 20 mini retirements before I am 59 1/2? Are there ways to do this in an intelligent and tax advantaged way? How important is traditional “retirement” saving if you never plan to traditionally retire?

    Hope you can address some of these issues as you continue this series. Thanks for sharing your wisdom.

    Like

  13. Regardless of your investment strategy or tolerance for risk, the single biggest factor impacting your investment results will be your behavior.

    In other words, do you have the discipline to hold on when everyone else is selling or the good sense to protect your gains (through rebalancing) as the market hits new highs?

    Costs are certainly important — I agree. But even if you have the lowest cost portfolio available for your needs, the portfolio won’t do you any good if you don’t have the patience and discipline to let it work for you over time.

    And to be clear, I’m not suggesting that I or anyone else can predict or time the markets. I believe in low cost, highly diversified asset class (index) funds and believe you should literally buy entire markets both domestically and abroad and let the power of capitalism work for you over time. It’s not particularly exciting, but it works.

    But in the end, it’s all about behavior. And if good financial advisor can help you do the prudent thing even when every fiber in your body is screaming at you to follow the crowd, then I think an advisor’s fee is worth every penny.

    Like

  14. I’ve recently started to max out my 401K and am now putting about as much money as I can into a well diversified portfolio with a money manager, as I realize we’ll probably never see a better time to buy in our lives. However, I’d also like to do some investing on my own with a much more aggressive approach, but not an amount that will really affect me if I lose it, so ‘play money’ if you will.

    Well, I’ve narrowed it down to they TYPES of companies I want to invest in, but I don’t know where to go to research SPECIFIC companies. I’ve basically decided that I want to find some pretty speculative stocks in the Energy Technology market as well as the Biomedical markets(stem cell treatments and biologically based medicines).

    So my question is where can I go to research companies in these sectors? Are there industry magazines or websites that highlights up and coming companies? This might be a stupid question, but I’m literally just starting to invest and have no clue where to look.

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  15. Tim,

    Your allocation seems to be 180 degrees from what Warren Buffett is doing. In a recent article – http://money.cnn.com/2008/10/17/news/economy/buffett_op_ed/index.htm?postversion=2008101709 – Buffett states he has moved virtually his entire personal portfolio from treasuries to U.S. stocks.

    He offers this great quote: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.”

    Like

  16. Great article Tim, helps to show all different views of the market that aren’t as publicized. Also i took that race test and scored a no preference my first time…

    Like