Viewing your portfolio through the right lens

One of the positive consequences of the current lockdown is that it does provide the opportunity to revisit a few of those old tasks, hobbies and pleasures that always seem to get put on the back burner in our busy lives. For some that might be picking up a new or re-reading a favourite book.

Here is an example of the latter: in the early 2000s Nassim Nicholas Taleb published a wonderful book titled ‘Fooled by Randomness’ with the descriptive sub-title ‘The hidden role of chance in life and in the markets’. In it he compares the wealth of a dentist to a wealthier Wall Street trader. The trader makes more money and lives in a far bigger house than the dentist, based on the one life that they have both lived, so far. Yet on an ‘expected’ basis, the dentist is wealthier because if one re-ran the personal earnings drawn from a dental practice over many alternatives lives, each would come out broadly similar (teeth need to be cared for after all). The product of the outcome and the probability reflects a dentist’s ‘expected’ wealth, which is quite consistent and, to a large extent, divorced from randomness.

On the other hand, the trader’s wealth represents the spoils of one life that is potentially the outcome of randomness and hides the left tail risk of complete disaster (e.g. losing lots of money, being fired, defaulting on the mortgage and getting divorced!) and all of the other less lucky lives the wealthy trader could have lived, or other unsuccessful/unlucky former traders have already travelled. The dentist’s wealth on this basis, makes her the richer person!

Taleb also uses the analogy of playing Russian roulette which – as any who has watched the Deer Hunter will know – is likely to end in tragedy. Many people – such as the trader above – play Russian roulette in their investment lives, only with a gun with far more empty chambers. At some point, the chamber with the bullet in it will end up against the firing pin, with often disastrous portfolio consequences. However, because the event is rare, it often gets ignored. In the meantime, their investment life may be extremely rewarding.

From an investment portfolio perspective, one cannot simply use the lens of past (single life) returns – particularly with 20/20 hindsight (e.g. ‘we should have had more in US growth stocks and less in global value’) – to judge a portfolio. It requires a lens that looks at ‘expected’ outcomes and the chances of them occurring. We should ask ourselves whether over multiple lives – like those of the dentist and the Wall Street trader – the expected outcome of a portfolio structure is higher than the expected outcome of other alternative portfolio strategies.

Taleb provides further wisdom:
‘Over a short time increment, one observes the variability of the portfolios, not the returns. In other words, one sees the variance, little else. I always remind myself that what one observes is at best a combination of variance and returns, not just returns (but my emotions do not care what I tell myself).’ Nassim Nicholas Taleb, Fooled by Randomness

The investment weather can be exceptionally varied and one of the goals of good portfolio construction is to make sure that all the bases are covered. In structuring client portfolios, we seek to avoid the single left-tail bullets that ultimately result in the cardinal sin of investing – permanent loss of capital. Amongst these are concentration risk (e.g. too much in any one stock), liquidity mismatches between a fund’s investors and its underlying assets (e.g. bricks and mortar property funds), low quality bonds (default risk), active manager risks (e.g. Woodford), non-UCITs products and opaque investment strategies, to name a few. A broadly diversified global equity core across all markets, sectors, and companies, balanced with higher-quality bonds as necessary, provides structural robustness, if not necessarily the best absolute outcomes over specific short-term periods.

As Taleb states:

‘One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way).’
Nassim Nicholas Taleb, Fooled by Randomness

We think that with the longer-term horizons of most clients, combined with the broadly diversified portfolios that they own, which have excluded the key sources of permanent capital loss, are well positioned to navigate the future. It may be less glamorous to look in people’s mouths for a living than to be the Wolf of Wall Street, but it should pay higher dividends over time!

Jonathan

About the Author

Jon is a highly qualified and experienced Chartered Financial Planner and Certified Financial Planner with over 27 years’ experience. He loves working with clients who are passionate about getting the most out of life and feels his job is to support them living life to the fullest. Read more from Jonathan...
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Just a line to thank you for the meeting today, and for another of year of prudential stewardship of our assets on your part. Graham & Liz

Expert Opinion…

5 staycation destinations for an early break in 2021

Jonathan, December 11th, 2020

With the four nations split in their response to the coronavirus pandemic, different tier systems, lockdowns, and local restrictions could apply across the UK at the start of the new year. But with vaccine rollouts starting and the potential for more areas to come out of the higher tiers as the overall […]

Read More
Your guide to the art of perfect sleep

Dominic, December 11th, 2020

Sleep plays an important role in our physical and mental health. A good night’s rest can heal and repair our bodies and consolidate memories. Prolonged bad sleep, on the other hand, is linked to high blood pressure and problems such as anxiety and depression. A good night’s sleep is crucial but not […]

Read More
5 tips for a better work-life balance as a business owner

Dominic, December 11th, 2020

Striking a positive work-life balance as a business owner has been difficult this year, but it is vital for physical and mental health. Here are five tips to help.

Read More
T: 01993 772467      E: advice@expertwealth.co.uk

Expert Wealth Management, West Wing, The Old Dairy, High Cogges Farm, Witney, Oxfordshire, OX29 6UN


Your Protection: In the unlikely event of your ever having a complaint which we have not been able to resolve amicably, you have recourse to the Financial Ombudsman Service (FOS). This is an independent body which will investigate complaints at no cost to you.  The FOS website is www.financial-ombudsman.org.uk.

Join The Expert Wealth Family As A Paraplanner >