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IF YOU KICK AROUND Wall Street for long enough, you’ll witness all kinds of investment fads—special purpose acquisition companies, cryptocurrencies, meme stocks, to name just a few. Each bubble differs, but the eventual comeuppance always feels brutally familiar.
But there aren’t just fads among investments. There are also fads among investment concepts. But while naïve investors tend to get caught up in investment bubbles, it’s the brainy types who fall in love with investment concepts, which they then promote with a religious zealot’s fervor.
Below are four such concepts. All ended up disappointing their most rabid fans. But despite that, each also has an important investment lesson to teach us.
1. Modern Portfolio Theory. When I started writing about personal finance in the late 1980s, cutting-edge financial advisors were focused on building portfolios that sat on the so-called efficient frontier. The efficient frontier—a crucial component of Modern Portfolio Theory—supposedly offers a menu of possible portfolios that’ll deliver the highest expected return for a given level of risk.
Those portfolio mixes were typically built on past performance, including the historical correlation among different investments. For instance, if an investment had generated high returns while performing quite differently from other asset classes, it would typically receive a hefty weighting in the portfolios found on the efficient frontier. After all, the investment in question promised to boost performance while also zigging when other investments were zagging, thus lowering a portfolio’s overall volatility.
Sound like a neat trick? Problem is, all this was usually based on past performance—and, as every investor eventually learns, past performance is no guarantee of future results. In the late 1980s, portfolios that sat on the efficient frontier typically included hefty allocations to Japanese stocks. The Japanese market had, of course, been generating gangbuster returns—an astonishing bull market that came to an equally astonishing end. More than 33 years later, the Nikkei remains some 30% below its year-end 1989 all-time high.
Lesson: While creating the ideal investment mix has proven far harder than running a portfolio optimizer that considers past risk and return, we shouldn’t dismiss the underlying goal—to construct a portfolio that includes uncorrelated assets. If you own just technology stocks, or just energy shares, or just high-dividend companies, your long-run returns may be fine, but the ride could be awfully rough and some investors won’t be able to stomach the turbulence. Want to sleep better at night? Make sure your portfolio is invested in all kinds of different stocks, and also includes at least a little money in bonds or cash investments.
2. Monte Carlo analysis. To state the obvious, high investment returns make it easier to achieve our investment goals. But the degree to which those returns help depends on when they occur during our lifetime. A bull market in our 20s won’t be much of a bonanza, because we likely won’t have much invested. But that same bull market in our 60s could allow us to afford every luxury on our retirement bucket list.
The importance of the sequence of returns captured the imagination of thoughtful financial advisors in the early 1990s, and led many to start using Monte Carlo analysis. What’s that? Imagine we took, say, the past 100 years of annual results for stocks, bonds, cash investments and inflation. We then assumed those annual results occurred in a random order and we repeated this exercise 1,000 times.
What we’d have are 1,000 possible market scenarios under which to examine how a portfolio might perform. Some of these hypothetical results would be great, and some would be terrible. But even if the results were terrible, would we still have enough money if we were saving for retirement or if we were drawing down a portfolio in retirement? Monte Carlo analysis can help us put a number on our plan’s chances of success.
But as Adam Grossman noted last week, Monte Carlo analysis offers a one-dimensional assessment of risk—one that hinges on the assumed investment returns. Still, that doesn’t mean we should ignore the key idea underlying Monte Carlo analysis.
Lesson: It isn’t average annual returns that matter, but rather what order we earn those returns. A bad sequence of returns can really bite if it happens early in retirement. Imagine quitting the workforce at the start of a year like 2022, when stocks plunged while the inflation rate jumped. Our comfortable retirement could be imperiled by the double whammy of falling investment prices and our own need for spending money. Faced with that threat, we should avoid selling stocks and minimize our portfolio withdrawals, thereby giving our nest egg a chance to recover.
3. Endowment model. During and after the brutal 2000-02 bear market, many investors—both individuals and institutions—cast around for ways to invest that weren’t so beholden to the vagaries of the stock market. They drew inspiration from David Swensen, Yale University’s chief investment officer, who had allocated a hefty portion of the university’s endowment to private equity, hedge funds, real estate and other alternative investments, and had done so with great success.
But the so-called endowment model has since lost some of its luster. The inability to sell many alternative investments amid market downturns caused major problems at some universities during the 2008 market crash. On top of that, the endowment model’s results over the past decade have been lackluster. Indeed, I’m no fan of alternative investments, which often involve high costs and occasionally produce wretched results. Want an investment that’ll hold up well during market declines? I’d favor the low-cost simplicity of short-term government bonds.
Still, while I don’t believe the endowment model is something everyday investors should emulate, underlying the model is a crucial idea—that endowments should turn their long time horizon to their advantage by allocating a significant portion of their assets to investments that may take years to come to fruition.
Lesson: Far too many investors focus far too heavily on short-run results, and yet most of us have surprisingly long time horizons, and we can take advantage of that by allocating a hefty portion of our portfolio to stocks.
For instance, if we’re age 65, we’ll probably spend no more than 40% of our portfolio’s current value over the next decade, and likely far less than 40% once subsequent investment gains are factored in. That means the time horizon for the remaining money is 10-plus years, which should be plenty of time to earn healthy stock market gains. What if some of our money will end up getting bequeathed to our grandchildren? The time horizon for those dollars might not be 10-plus years, but more than 60 years.
4. Factor investing. Modern Portfolio Theory posited that if investors held a diversified portfolio but upped the risk level—as measured by volatility—they could expect higher returns. But reality didn’t match the theory. Some segments of the stock market, such as smaller companies, value stocks and those with price momentum, were found to earn higher returns than could be explained by volatility alone.
In the 2000s, the growing list of market “anomalies” culminated in an explosion of so-called factor investing, also dubbed “smart beta.” Money managers rushed to market with exchange-traded index funds that tilted toward stocks with low volatility, price momentum, high gross corporate profitability and countless other attributes. But many of these funds ended up generating disappointing results, plus questions were raised about the validity of the underlying research—the so-called replication crisis, which found that many of the original studies underpinning factor investing didn’t hold up to close scrutiny.
Lesson: Like many investors who pay attention to academic research, I tilt my portfolio toward smaller-company and value stocks. That helped my results in 2022, but I strongly suspect it hasn’t helped over the long run. Still, I’m hopeful that these portfolio tilts will be a plus in the decade ahead, but I also readily concede that adding these tilts has introduced a key risk—the risk that my results will lag behind the broad market averages.
Indeed, while factor investing has disappointed many devotees, it’s highlighted an important insight: There’s more to risk than volatility. We also need to be alert to countless other investment risks, including inflation, deflation, lack of diversification, home bias, overconfidence, weak property rights, excessive leverage, badly lagging the market averages, sequence of returns, outright fraud, high investment costs and changing tax laws. And to that list, perhaps we should add one more: the risk we’ll fall in love with the latest investment concept.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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>> the risk we’ll fall in love with the latest investment concept.
So true!
It’s reassuring to know that a portfolio of small & large value has been able to sustain an annual inflation adjusted income withdrawal of between 3.5 – 7%, accompanied by terminal portfolio growth, over seventy-two rolling 20 year periods since 1931 up until present ( this using a simple conditions based methodology https://tinyurl.com/yckmev96 ).
And in the income stage, an investor shouldn’t worry about their portfolio having to “beat a benchmark” – the portfolio just needs to do it’s job of providing an income stream.
Very well written article and several thoughtful comments – these are good reasons I keep up my monthly donation
ESG belongs in the same trash heap as the other woke acronyms, DEI, BLM, etc. Any investment should be looked at through the acronym WTF.
Jonathan, thank you for this. Your ability to explain the “big concepts” to amateurs like me is much appreciated.
Hi Jonathan, this is Chris. Thanks for today’s column. I didn’t know what some of these terms were and your explanations were understandable. We didn’t get caught up in some of these. Try to keep things plain vanilla. If I don’t know what something is or don’t understand, we don’t invest in it. Spouse lets me be lead on our investments but we talk things over together. It helps that I have to explain to them, since they know less than I do. It has served us well so far. LOL!
As Bernstein says, The goal in retirement is not to optimize returns, but rather not to die poor
Thank you. A very good article. I’ve come to the conclusion after many years that successful investing need not be complicated. Unfortunately, however, it requires an ability to sometimes do nothing when our normal impulses are screaming for us to do something.
This is one of the best posts I’ve read in a while. It reminded me of the many lessons to be learned from Nassim Nicholas Taleb’s book “The Black Swan.”
Taleb stresses that the future is not merely unknown, but unknowable. As much as we’d like to predict the one future that lies before us, we actually face a range of possible futures. The Achilles Heel of Modern Portfolio Theory appears to be its reliance on past data. It certainly carries more weight if the future before us turns out to be similar to the past we’ve just experienced. But if not, as Jonathan points out, we may overemphasize certain investments that performed well recently, but turn out to perform poorly when the investment landscape suddenly changes.
Sequence-of-returns risk is certainly an important consideration if we plan to retire soon. To avoid selling stocks and minimizing withdrawals if we’re bitten by a bear market early on, we need to carry a hefty allocation to liquid invesments. Yes, this will be a drag on future returns but, to me, the benefit would outweigh the cost of a severely diminished portfolio. Call it a form of insurance.
As always, diversification is a good way to deal with the numerous investment risks we face. A concentrated portfolio in a bull market might yield great returns, but would likely suffer devastating losses in a bear market. Like the tortoise and the hare, long-term portfolio resilience will beat a focus on short-term gains.
We’ve all heard of studies of the stock market’s return over some extended period where missing only a handful of days would significantly reduce the return we theoretically could have earned if we stayed the course. The stock market often doesn’t rise at a measured pace, but is listless for a while, then suddenly jumps higher. These jumps can’t be predicted. If we try to market-time, we’ll likely miss the benefit of these positive black swans by being out of the market when they occur. Yet another reason to think long-term and stay invested when your neighbors boast of making a killing in options. If history is any guide, many of those outsized returns will prove to be ephemeral.
The older I get the more I realize that Bogle was right, simplicity wins with buy and hold and rebalance, and all the Noise is really meaningless. What retirees need to understand before retirement is SORR. A 50% portfolio drop at the onset of retirement is a portfolio death sentence
A quick recovery from a large drop, as was the case following the Great Recession, greatly limited the pain felt by new retirees who didn’t panic.
Add this one to the Top 10 list, Jonathan – great job laying out the various investing frameworks and tools that have gained currency at one time or another. Since you have Monte Carlo in there, you could also add the 4% rule – or maybe that’s part of a second similar article about retirement decumulation theories and trends?
Your reflections on Monte Carlo in this one triggered a new insight for me: one of the principal benefits of Monte Carlo is that it really highlights the reality of sequence of returns risk, not just producing an estimate of the probability of portfolio success. Never thought about it that way before, but it absolutely does that. Whenever I run it, I end up with results showing that after 40 years I’ll either be broke before I die, or have enough left over to donate a new wing to the library at my alma mater. SORR!
I consider the 4% rule to be intimately connected to Monte Carlo analysis and sequence-of-return risk. What Bill Bengen illustrated in his original article was that, if you retired at a bad moment for the markets and inflation, a 4% draw wouldn’t deplete your portfolio over a 30-year retirement.
Which actually makes it a pretty useful checkpoint.
“All models are wrong, but some are useful”. George E. P. Box (British statistician)
As a retired engineer previously involved in analytical modeling and design optimization, Box’s quote was in important warning. Simulation (e.g., Monte Carlo analysis) is an important design step, but critical thinking may be more so. All the same concerns are applicable to investing.
Re: your tilts: What I love about value index funds is the underlying companies rarely do stupid things that suddenly lose a lot of money. They tend to die slow, predictable deaths rather than blow up or melt down like their growth counterparts. When you have new cash to invest you can tell if they’re “on sale” or too expensive. And because they’re less likely to be wildly overpriced, their dividend yields are usually higher than growth ones. They produce just enough growth and income for my retirement needs. Perfect for time and compounding to do the hard work. I use a value tilt on both US and ex-US holdings.
Nice article, Jonathan. In my humble opinion, if we all stick with Bogglehead’s investing principles, most of us will work out well, in the long term.
3 Fund Boglehead Portfolio will beat more than 90% of investors. Everything we read in reality promoting different strategies is meaningless. Simplicity=Success
But some will say ( in their sales pitch), what about the 10% that are beating the market? I can be done! Yes there are those who beat the market…. But none consistently over the long term, and we don’t know who these out performers will be.
There are investors and then there are the rest and great majority of us who are savers looking for a place to put money and see it grow over a long time.
I think the problem comes when those of us looking to accumulate money for retirement start thinking we are investors and just jump on the next bandwagon. I don’t think I know any true investors. There certainly aren’t many among 401k participants.
Depends on one’s notion of what constitutes an investor. Personally, I consider my mix of index funds, real estate, and annuities/bonds an investment portfolio based on what I have learned from a few seminal books and the writings of folks like Mr. Clements.
Well said Mr. Quinn! Actually I think Jonathan Clements is a true investor, as he’s demonstrated by his equanimity in the face of market panics by following Warren Buffett’s advice to be greedy when others are fearful and vice versa. But my wife and I, along with 90% of the other people we know, are in the other camp.
One of the insidious thing Wall Street does – aided and abetted by the financial news media – is to create the impression that investing in stocks and bonds is the only option to secure one’s future, when many if not most people would sleep better and be better off owning some income property and/or focusing on having a floor of safe income (through TIPS ladders, late Social Security claiming and yes, even some annuities), with a modest supplemental position in globally-diversified equities on top.
I think that a lot of what drives the interest in Modern Portfolio Theory and the Endowment Model is that so many of us savers feel forced to be investors and are always looking for the allocation that’s going to give us ~6-8% real returns with as little danger of deep or prolonged drawdowns as possible. Real investors like Mr. Clements can stomach volatility and don’t mistake it for risk but few of us are made from such strong stuff.
Adam Grossman’s 2022 article “Shades of Green” and the comments present several views.
Thanks for the comment — but readers should note it relates to the ESG comment below.
Yep, sorry. I tried to add “Martymac: ” but couldn’t edit it.
I was a huge fan of “Momentum Investing” in 2021, but not so much in 2022. Now if only I could predict when the “Mo” changes.
i thinks it’s human nature to be attracted to fads. I once thought that healthcare was strictly science-based and immune to fads. I’ve learned, however, that when someone with a marketing bent lays hold of an interesting concept, it can be misapplied and over-promoted. The sifting process may eventually reveal a new nugget that is truly helpful, but often attention has moved to the next fad.
How right you are. There are in fact trends in health care. When I managed plans years ago you could see what was hot. TMJ was a hot item, Lyme disease was ot, etc.
Yes, investors have been searching for decades for a magic formula that allows them to invest without examining the actual companies.
But if you want to make money, nothing beats look at the corporate financials, the quality of management, and the underlying business model. It’s boring, it’s old fashioned, it’s tedious….but it actually works. Warren Buffett has spend his life reading 10K reports, and that’s what you have to do.
Well yes, but Buffett also transitioned about 40 years ago to a one that more emphasizes qualitative things. He’s spoken eloquently of this shift. How now he wants to find companies that have business so good you don’t need a spreadsheet to know you want to invest in it. So there is the Grahamite early Buffett and the later Buffett.
I avoid all that boring effort by investing in low cost index funds. No magic formula wanted – I am happy with the market return.
What’s trendy is more important for stock price than anything else, and this is difficult (or impossible) to predict.
Excellent as always. One of the latest fads of course is “responsible investing” or as you know ESG. Creating wealth and doing good.
I’m curious how others feel about “sustainability “ investing and ESG?
ESG is just another crime scene kickback for supporting a political agenda.