The Big Win

One of my favorite finance guys is Ramit Sethi, writer of the “I Will Teach You To Be Rich” blog (and book by the same name). We disagree sharply on investment strategy, but I love his overall philosophy of focusing on the “Big Win.”

For example, instead of spending time writing yet another austere budget that will undoubtedly be abandoned in a few weeks, spend that limited time and willpower on planning a negotiating strategy for your next salary review. Hustling for some extra money with a side job or freelance gig could be worth fifty times what you might save by cutting down on your Starbucks habit. That’s the basic idea – focus on a small number of truly meaningful concepts instead of endlessly battling to deprive yourself of comparatively minor things that you really enjoy.

There is a direct parallel to investment strategy here. The typical approach, which is surprisingly shared by Ramit, is pretty simple:

  1. Establish an age-appropriate diversified asset allocation plan.
  2. Populate that plan with low cost index funds.
  3. Periodically rebalance investments to adhere to the allocation plan.
  4. Dollar cost average into your investments on a regular basis.

Seems reasonable, but totally ignores one of the Biggest Wins in investing – a strategy for not losing most of your money. That might sound hyperbolic, but it’s really not. Deep and enduring market declines are a regular occurrence throughout history. Countless fortunes have been lost due to misplaced faith in the equity markets and, until someone comes up with a human nature vaccine, countless more will be lost in the future.

If you are a Japanese investor you’ve witnessed a steady, relentless, 75%+ erosion in the Nikkei over a period of more than twenty years. Dollar cost averaging by way of monthly contributions would have been a disaster with virtually every deposit for more than two decades losing money.

If you are one of the millions of Southern European investors with a diversified portfolio, you’ve been rocked by stock, bond and real estate values that have all dropped at the same time. Since the beginning of 2008, Greek stocks are down more than 90%, home prices are down more than 20% and government bond values have been shattered and face the very real possibility of default. Not to belabor the obvious, but if your stock portfolio has suffered a 90% decline, the odds of recovering that money within your investing lifetime are pretty slim.

Spain, Ireland and Portugal have experienced differing degrees of the same thing. This isn’t unprecedented. As long as there have been markets there have been market crashes and there is nothing about the U.S. markets that makes us permanently immune to something similar. This isn’t a prediction, just a statement of fact.

Low-cost passive investment vehicles are great, I use them extensively. However, the Big Win in investing isn’t saving half a percent in expenses. Preventing a thirty or forty percent loss (or worse) in an ugly bear market? That’s a Big Win. To do this, you don’t have to be able to predict anything. You don’t have to immerse yourself in market research or stay on top of geopolitical events. But you do have to change the way you think about investing:

1) Get comfortable with the idea that stocks, bonds and all investment securities are just tools. We invest to make money – these tools are simply a means to that end. Like any other tool, sometimes they are helpful and sometimes they can inflict great damage. When the probability of harm outweighs the probability of benefit, step away.

2) Admit that losses are inevitable. No investor is perfect, but many seem to expect perfect results. Losses will happen. Plan for it. If you can keep them small while letting the winners run you are stacking the odds of long term success in your favor. If your reaction to a losing position is to ignore it in hopes of an eventual turnaround, you could be in big trouble. If your reaction is to seek out information that confirms your bias while discounting conflicting data, you could be in big trouble. It’s okay to be wrong as long as the damage is contained to a manageable degree.

3) Realize that the equity markets don’t care how patient you are. Stocks offer no assurance of a positive outcome no matter how long you stay invested. For some reason, this notion persists, even among smart people like Ramit. There are dozens of examples, like those above, of current and historical markets that have produced negative returns over an investing lifetime. It’s not just stocks either, there are scores of examples of sovereign bond defaults, not to mention a vastly greater number of corporate defaults. Real estate? Commodities? Currencies? It is naive in the extreme to believe that a market or a position will always come back, especially in the time frame that you need.

4) Adjust your expectations to reflect reality. How often do you get something for nothing? Almost never, right? Why then, do so many people believe that investing should be the exception to that rule? For doing nothing other than writing a check or allowing a monthly payroll deduction, they expect that no matter what happens in the world, they will receive a long term positive return that outpaces inflation. They might say, “I’m not doing nothing, I’m taking risk!” without pausing to understand that taking risk means the exact opposite of assuring a positive return. It means there is a chance of substantial loss. That’s why it’s called risk. Just like any other endeavor, earning a positive return over a long period of time takes work and it’s more complex than an index fund salesman might like you to believe. You’d think that would just be common sense but, for some reason, it’s not.

So, what’s the alternative? There can never be a single permanently best solution – there are too many highly motivated market participants all looking for the same thing for that to happen. However, improving on a strategy that largely depends on faith in market altruism may not be as elusive as we’ve all been led to believe.

There is more than one way to skin a cat, but I will admit to a bias toward a systematic, probability driven approach. Mainly because I have a bias toward concepts that are logical and don’t depend on future-telling abilities to work. Here are a couple of research pieces that any open-minded, data driven investor should find interesting:

  • Morningstar Model ETF Portfolios Excerpt: In virtually every equity, currency and commodity index we tested, moving-average-based timing schemes reduced drawdowns without sacrificing return (in many cases improving it). The improved risk adjusted returns can’t be explained by the increased average exposure to cash or to a few anomalous periods.
  • A Quantitative Approach To Tactical Asset Allocation Excerpt: A non-discretionary, trend following model acts as a risk-reduction technique with no adverse impact on return. When tested on various markets, risk-adjusted returns were almost universally improved.

Controlling expenses is important. Nobody wants to pay unnecessary fees nor should they. It’s an easy win. It’s a big win, but it’s not a Big Win. Participating in a long, powerful bull market is a Big Win. Protecting your assets from disaster is a Big Win. There is no reason not to take the easy wins when they present themselves as long as we keep our priorities straight.