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AS THE SAYING GOES, a picture is worth a thousand words. Over the years, I’ve found certain images and illustrations to be immensely helpful in discussing investment concepts. These are the ones I’ve relied on the most:
Only in Australia. A key challenge for investors—if not the key challenge—is that none of us has a crystal ball. It’s impossible to know what markets will do next month or next year. As a result, all we’re left with is our best guess and, for that reason, it’s natural to extrapolate from recent history. The problem is, there’s a first time for everything. We can never be too confident that something won’t happen, even if it hasn’t happened before or hasn’t happened recently.
This notion was best illustrated by author and retired investor Nassim Nicholas Taleb in his book The Black Swan. In most parts of the world, swans are white—but not in Australia, where most are black. But if you’d never been there, and if every single swan you’d ever seen was white, you might feel safe in concluding that all swans are white. The lesson: Don’t dismiss risks and possibilities out of hand just because they seem unlikely.
In a new home. Suppose you were furnishing a new home. How would you go about it? If you’re like most people, you’d start with the basics—a table and chairs for the kitchen, a couch for the living room, and so forth. You probably wouldn’t start by purchasing an umbrella stand. That would be nonsensical.
But that’s the way the investment industry markets mutual funds to consumers. Open a financial publication or go to a financial website, and you’ll often see ads promoting all sorts of different funds—everything from stocks to gold to cryptocurrencies. As a result, many people start their investing careers by assembling a collection of investments without an overall blueprint—like buying an umbrella stand before anything else. A better way: Tune out Wall Street’s marketing machine and instead think about building your portfolio the same way you’d build a home, with an overall plan as your first step.
In the war chest. It’s common to think about asset allocation in percentage terms. You might, for example, ask whether you should have 50% or 60% in stocks. While that makes sense, I also recommend thinking in dollar terms—specifically, the amount of dollars you hold outside of stocks.
Suppose you’re retired and require $100,000 a year from your portfolio. As an asset allocation, I might suggest holding $500,000 to $700,000 in a combination of cash and bonds. Those are the dollars that would help carry you through a stock market downturn, and I wouldn’t worry too much about that sum as a percent of your portfolio. Fellow financial planner Matthew Jarvis calls these cash-and-bond dollars a “war chest,” and I think that’s an excellent image.
In the studio. Pablo Picasso was obviously very productive, but the state of his studio might have led you to think otherwise. It was a mess. Among the canvases lived an assortment of cats and dogs, as well as a monkey that liked to sit on the artist’s shoulder as he worked. But a lot of good work emerged from that chaos. The lesson for investors: Know what’s most important, focus your energy on getting those basics right, and don’t fret too much about the rest.
On the elevator. Mutual funds make it easy for investors to build diversified portfolios. But they’re not perfect. A key flaw: A fund’s gains or losses are shared pro-rata by all of its shareholders. Normally this isn’t an issue, but in market downturns it can be a problem.
That’s because downturns will always cause some investors to become spooked. If enough shareholders request redemptions from a fund, it can cause the fund manager to sell holdings, triggering a tax bill for the taxable-account shareholders who remain. That’s why I compare being an investor in a mutual fund to being a passenger on an elevator: Everything will probably be just fine—as long as everybody else behaves. But since the world is unpredictable, I try to minimize that risk by sticking to exchange-traded funds (ETFs), and especially to index-based ETFs, which are structured in a way that lend themselves to being more tax-efficient.
On the farm. I’ve often quoted what I believe to be the only published poem in the world of personal finance. In 1938, John Burr Williams included these words in an otherwise math-filled volume called The Theory of Investment Value:
A cow for her milk
A hen for her eggs
An orchard for its fruit
Bees for their honey
Williams used this image to illustrate a key concept in finance: intrinsic value. The idea is that an investment only has value because it can produce something. Stocks, for example, can produce dividends. Bonds produce interest. Real estate produces rent. That’s why I avoid things, such as cryptocurrencies, which might be interesting but have no intrinsic value. The risk: Assets lacking intrinsic value are worth only what the next person is willing to pay for them. That makes their prices more volatile and unpredictable.
In the infield. Warren Buffett has offered his own colorful illustration of intrinsic value. If you took all of the world’s gold, he noted, it would form a cube about 67 feet high. It would fill most of a baseball diamond. That might seem valuable, but what would it do for you? Buffett says, “You could get a ladder and climb on top of it… you could polish it… you could stare at it… but it isn’t going to do anything.”
In other words, gold—unlike stocks and bonds—doesn’t produce dividends or interest. “All you’re doing when you buy that is hoping that somebody else… will pay you more to own something that, again, can’t do anything,” says Buffett. While gold is a bit of a special case because of its long history, the point remains: If an investment isn’t capable of producing any income until you sell it to someone else, it’s going to be inherently more risky and its value more subjective.
At home. In recent weeks, I’ve discussed the risk posed by hackers, and that’s one of the reasons I recommend not holding all your assets at the same institution. That said, I do favor consolidating most of your assets under the same roof. Here’s how I think about it: Suppose you’re babysitting two children. To keep things under control, it’s best if they’re both within your line of sight. But if one is playing in the yard, and the other is running around in the basement, anything could happen. It’s the same with your portfolio. The fewer places you have to keep tabs on, the easier it’ll be to monitor your portfolio and to make changes.
On the road. Some years ago, I was heading to a meeting in Upstate New York. At a certain point, I realized I was going too fast, and for no good reason. If I slowed down, I still would’ve gotten there on time. But if I’d gotten pulled over, then I would’ve ended up being late. It’s the same with asset allocation. We all want our investments to grow. But if we hold too much in stocks, it can end up backfiring. Sometimes, it’s better to slow down a little, so we avoid getting derailed.
Running away. Groucho Marx famously said, “I don’t want to belong to any club that would accept me as one of its members.” Years later, venture capitalist Andy Rachleff offered investors advice along the same lines. The most successful venture capital, private equity and hedge funds, Rachleff explained, have no shortage of potential investors, such as university endowments willing to write eight- or nine-figure checks. It’s only investment funds with poor track records that are out marketing their funds to individual investors. So, if you’re on the receiving end of a pitch like this, Rachleff says, “Run away.”
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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There is lots of good advice here. I find it interesting that it comes from a fee-based financial adviser. I find many of my friends who consult with me about investments enjoy the comfort of a paid and trusted adviser.
I point out to them that a 1% fee is equivalent to about 20% of an overall 5% return. I ask them if they feel this adviser is worth 20% of their investment income. For some of them, it is.
Those investors either prefer not to do the work a good adviser will do or they feel incapable of doing that work. Often it is a combination of both. Schwab however recently got penalized for doing what almost every adviser does–taking a fee for money they were keeping in cash or something similar as part of an overall managed portfolio.
So I’m wondering, Adam, when you recommend that your investors keep that “$500k to 700k” in cash and bonds, do you still collect a fee as an investment adviser on that money? I’m guessing you probably do.
It is also true that the best investment advisers, like the best hedge funds, may end up with high dollar value clients. So is it not also true that the ones available to lower dollar value clients, like those with less than $500k invested, are perhaps either not proven or even not so great? I tend to think this may be true.
I like the term “War Chest”. How we frame something affects how we think about it and make decisions. For example, I decided to keep 10 years worth of future withdrawals in cash and short term bonds, which comprises 30% of my portfolio, leaving 70% to invest in stocks. Someone else might read about the historical performance of portfolios with various allocations, and chooses 70/30. So we end up with the same allocation, but for different reasons. I might be more likely to stick with my allocation in the future as long as I still think it is desirable to keep ten years worth of withdrawals liquid, than if I settled on the allocation for other reasons.
Nice article! I particularly like the piece on intrinsic value. Validates my decision to avoid things like cryptocurrency – my most exotic investment was an emerging market fund, and I no longer hold that.
I am a little concerned about the recommendation to hold assets in more than one place – all of mine are consolidated at Vanguard.
Yeah, that raised a concern for me as well. Thinking about it, I came up with 2 risks. First, disruption of services. If there was a major cyber event, even if one’s accounts eventually are fine there could be a delay in getting access to one’s funds. That might be problematic depending on ones circumstances. Second, there’s the limits of insurance coverage. SIPC protects brokerage accounts of each customer up to $500K including up to $250K for cash. Vanguard itself has a supplemental policy, but who knows how quickly that might get resolved. While I think it’s highly unlikely of a total Vanguard failure, I really don’t like taking risks that I don’t need to take. I need to give this some more thought.
I’m not so concerned about the first. I have a separate checking account at a local bank, which is where my pension and SS are deposited. I am concerned about the second.
Great illustrations. I use a lot of stories in my work to help patients understand difficult information. I’m not sure all are appreciated—-like comparing old bodies to old cars that wear out and can’t be expected to perform like new—-but the point often gets across. Metaphors and analogies are helpful.