Transparency is the currency of trust.
How I Invest My Own Money was recently released and I was compelled by the idea. What better way to strengthen that trust with clients than to show your own cards. One of the best questions you can ask when you are profiling financial advisors is how do they invest their own money. When you consider that 50% of fund managers don't invest in their own fund - that should raise red flags. I eat my own cooking. I use the same approach for my portfolio as I do for my clients.
THE GOAL is the same regardless of who is investing. That said, we all have unique circumstances that give us unique definitions of wealth that deserve to be treated, uniquely. That goal is...
Can I do what I want, when I want, with my money?
This requires a thorough examination and diagnosis of your personal environment (age, kids, retirement wishes, savings) as well as your attitudes about money and risk. Risk is both art and science. It’s real and emotional at the same time. It’s invisible until it’s not. I have to understand my risk spectrum - my risk required, my risk desired, my risk tolerance, my risk composure, and my risk capacity. An advisor should perform an MRI, a Meta Risk Investigation, so they can diagnose and prescribe, what is needed.
As Dr. Daniel Crosby says in The Behavioral Investor, “Humans are designed with dynamic risk preferences.” My mission is to design a portfolio to support those preferences.
THE CONCEPT is that there are subsets in an asset class that at any time are more favorable than others. I want to use analysis to determine the polarities between these subsets and know when to be in one subset or another. I steer clear of targeting sectors (such as Energy, Financials, etc.) as you never know when political winds will shift and adversely affect decisions and lead to false reads in any modeling. For the purposes of this article, I will call the subsets “Offense” and “Defense”.
MY STRATEGY is based on rules to identify evidence that there have been behavioral market shifts between subsets within an asset class. I navigate these polarities to determine when to focus on gains and when to emphasize losing less, understanding that the rules aren’t perfect and the sensitivities are dynamic.
MY INTENT is based on an approach that lies at the intersection of process, behavior, and evidence. I know at times this won’t work as expected and that sometimes, good decisions have bad outcomes (much like bad decisions can have good outcomes). This is why I evaluate and fine tune my triggers quarterly to minimize future occurrences.
Process: I have a transparent, rules-based process defined and I know ahead of time what will trigger a change. I know what my next action is, just not when it will happen. I perform retrospectives on trades for the duration of the holding period. My performance timeframe has nothing to do with where the earth is relative to the sun.
Evidence: The rules are based on creating a desire-able, but fully invested portfolio at all times. The rules seek to own strong performers when the market is trending up and safe harbors when the market is trending down. The evidence seeks to be right, not first, and find the more desirable subset at the time. The rules are a function of the holdings representing the respective subset and the timing sensitivity.
Behavior: This process and these rules are built around market behavior. Therefore, I don’t want to sabotage the results with my own behavior. Doing so would be the equivalent of trying to drive while wearing my glasses and my mom’s glasses. Do I experience downdrafts? Of course. Knowing this consequence is likely to occur, I understand that maintaining a consistent allocation provides a cognitive back-up plan that minimizes regret in case the outcome is subject to more luck, government intervention, or skill. This also gives me another form of diversification as I am managing a portion of my portfolio differently. It serves as a better “what if I’m right” or “I knew I should have” line of defense that to be in or out of the market. It makes my portfolio more anti-fragile. As Nassib Taleb describes it:
...antifragile loves randomness and uncertainty, which also means— crucially—a love of errors, a certain class of errors. Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them— and do them well...
...antifragility makes us understand fragility better. Just as we cannot improve health without reducing disease, or increase wealth without first decreasing losses, antifragility and fragility are degrees on a spectrum.
EXECUTION and Portfolio Construction begins by performing a Meta Risk Investigation (MRI) on our situation. I start with finding my risk tolerance using Riskalyze (I can do this for you as well - if interested in learning your Risk Score, email me at jc at myfinancialstrategies dot com). Riskalyze allows me to calibrate my appetite for uncertainty, given the associated risk/reward. The higher the score ranging from 1 to 99, the higher my tolerance for a broader range of outcomes, both good and bad. My risk score is a 60. The questions you get are kind of like a trip to the eye doctor. You will get a series of questions with a binary choice between two outcomes - one being certain and one being a range, with each subsequent question getting a little more calibrated and precise, until we can see 20/20 on what your Risk Tolerance is. This feeds into the rest of the risk spectrum.
Once I have the MRI results and my risk spectrum defined, I can determine how much of my portfolio should be in equities and how differently I should treat my taxable and retirement accounts. I have three account categories that I treat differently due to tax implications, greater diversification, and risk posturing.
Taxable Brokerage - Taxed When Sold
Retirement - Buy and Hold (Strategic)
Retirement - Buy and Mold (Tactical)
My Taxable Account is 48% Stocks, 52% Tax Exempt Muni’s which provides a risk score of 45. I want to balance maximizing liquidity and minimizing taxable events. I undershoot my risk score and I rebalance with my contributions or distributions using percentage cost averaging and tax sensitivity.
My Buy and Hold Retirement Account has a risk score of 62, whereas my Buy and Mold Retirement Account has a risk score range of 50 to 69. Using both approaches, along with taxable account, provides me with a 3-D view on investing
(1) Dynamic Risk Preference with a measured relief valve
(2) Diversified by Strategy and Asset Class
(3) Disciplined with rules around behavioral inflection points, process, and tax sensitivity
Buy and Hold is placed as close to my risk score as possible (in this case, 62). It is important to re-emphasize that my risk score doesn’t mean I need that much risk. I may be able to do everything I want in life with less risk. It may be more risk than I can afford to take, but it is a good place to start in defining that full risk spectrum. This is where the value of an advisor comes in to facilitate this conversation.
Morgan Housel offered the following in The Psychology of Money about taking more risk that what you need
To make money they didn’t have and didn’t need, they risked what they did have and did need. And that’s foolish. It is just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.
For some people, this is enough. For me, I want additional diversification with a complementary strategy that provides a dynamic risk adjustment. Enter the Buy and Mold Retirement Account which recognizes the importance of staying invested, the value of a rules-based process, and understanding that I am an emotional human, not a rational spreadsheet.
Buy and Mold is the result of a cocktail of ideas from Lawrence Hamtil, Corey Hoffstein, Meb Faber, and Daniel Crosby.
The key is to:
(a) stay invested,
(b) realize we are emotional creatures, and
(c) maintain process discipline.
I do this by following relative market trends between two subsets within the same asset class within the constraints of asset allocation and risk sensitivity. Let me use an example.
Lawrence Hamtil uses a “barbell” strategy of using factors together, like a balance between a Momentum Index and a Low Volatility Index. The results are attractive. Essentially, he is owning my Offense and Defense simultaneously.
In contrast, I use a “seesaw” approach. The seesaw approach owns either the Offense or Defense subset, depending on the relative trend between the two. I will look at the two holdings on a relative basis weekly and make any adjustments to the sensitivity quarterly. I do this across nine asset classifications, as I detail below.
How does relative trend work? For one of my nine subsets, I use the ETF symbol MTUM for offense, and I use USMV for defense.
In the graphic below, when the red line is above the black line, I own offense. When the red line is below the black line, I own defense. Given that I have to wait for enough data points, this calculation actually begins on 9/9/2013. Over nearly seven and a half years, this generated 21 trade signals between subsets of the broader index. What would those 21 trades “buy”? The backtest is the result of switching between Offense and Defense when the red and black line cross.
On a smaller scale, here is how one fortunate cycle worked out.
Between 2014 and 2016, the line is much flatter so the results aren’t as robust in that timeframe, but that is part of the process where skill could not be distilled from luck….welcome to investing. The goal is to make good decisions that result in good outcomes. Having good outcomes from bad decisions may feel good in the short term, but could create a false sense of security going forward with an eventual, emotional 1-2 punch of greed and regret.
NOTE: This one sliver of a portfolio is offered for illustrative purposes only. This is not investment advice and past performance may not translate to future results. My goal in sharing my process is to build trust, awareness, and understanding. When you look under the hood, everybody wins.
This may not be aligned with you philosophically or emotionally. This is one reason that your conversations with your financial advisor are a vital part of the investment process. If that is the case, don’t try this.
I repeat this across the following asset classifications. For each Asset Classification, the first index is Offense; the latter is Defense.
Asset Classification: Offense vs. Defense
U.S. Equity: Momentum vs. Minimum Volatility
U.S. Equity: Large Cap vs Small Cap or Equal Weight
Global: Index vs. Minimum Volatility
International: Momentum vs. Minimum Volatility
Emerging Markets: Momentum vs. Minimum Volatility
Fixed Income (Duration): Long-Term vs. Short-Term
Fixed Income (Issuer): Corporate vs. Government
Fixed Income (Quality): Junk Bond vs. Investment Grade
Fixed Income (Nationality): Emerging Markets vs. USA
How does this change my risk?
By switching between Offense and Defense, my risk score will fluctuate, even though my asset allocation does not. Here is the individual holding risk scores for the Offense and Defense that I just illustrated.
Offense, MTUM
Defense, USMV: 10 points lower risk, but still full invested.
The same concept works for bonds
Offense, ANGL - Junk Bonds
Defense, QLTA - Investment Grade Bonds, 18 points lower, but still invested.
When I look at the trend with each Offense and Defense subset, this is where I found my personal peace in investing. I have an anchor with my risk tolerance and the slack in my rope gives me some grounded, but rules-based behavioral freedom when the winds or the currents shift. It also is reassuring to know I am diversified by strategy as well as asset class.
I hope you have learned something from sharing these details. If you have, feel free to share your learnings with others and I welcome the chance to discuss them further with you.