The Beauty of the System

​Life gets complicated quickly. That doesn’t mean that our response needs to be complicated. I recently read the book Simple Rules by Donald Sull and Kathleen M. Eisenhart. They discuss the use of simple rules and why they are so successful in the face complex situations. These types of situations range from surgical triage to dieting. It turns out that simple rules can help us make much better functional decisions because they allow us to focus on variables that really make a difference while allowing for flexibility to pursue new opportunities as they arise.

Of course, this type of thinking is fundamental to the investing strategy that I follow. Those of you that have worked with me or followed me for a while know that I use a strategy that is simple in concept:
 

1. Understand your tolerance for risk: this is your ability to weather a draw down in your investment portfolio.
2. Build a diversified portfolio: we don’t know which asset classes will do the best over the short or long term. So we own an appropriate slice of many of them so we get our fair share of each asset’s return.
3. Rebalance: sell and buy assets based on their deviation from our target portfolio. This forces us to sell things that have done well recently and buy what has done less well. Giving us that ability to benefit from assets tendency to revert to the mean by “selling high” and “buying low”.

 
Although enormous amounts of research can and do go into the building blocks of your portfolio, once your strategy is developed, the system allows you to make rational and appropriate decisions when managing your investments over the long term.
 
Simple can be Beautiful
 
To illustrate this, lets consider a super simple portfolio strategy: 50% US bonds/50% US stocks with a value of $100,000.

This simple system already has some great benefits for our process. With regards to risk management, it can allow us to assess our ability to handle a significant drawdown. We know from recent US market history that stocks can lose up to 50% of their value in a market drawdown. This simple model lets us know that the portfolio would be subject to a reduction of $25,000, or 25%, if stocks were to drop 50% (assuming the bond portion stayed constant). We would also know in advance what actions we are going to take. In this case, we would sell $12,500 worth of bonds and buy stocks bringing us back to our 50/50 allocation.
 
Now, just because this is simple in concept, does not mean that it is going to be easy. Anyone who was invested during 2008-2009 knows that following your plan, no matter how rational, can be very difficult when you just saw 25% of your wealth evaporate. This is what we are worried about:

​Hypothetical US Stock Returns Scenario 1

In this case we would suffer a permanent destruction of our wealth. But history indicates that this is unlikely. Markets usually recover and eventually go on to make new highs. In that case our experience might be something more like this:

Hypothetical US Stock Returns Scenario 2

In this example, the market recovers its losses over the next two years. If this were to happen to our portfolio, and we rebalanced just once in the middle of the drawdown (again assuming our bond portfolio stayed constant), we would end the period with $112,500. This represents a return of 12.5% for riding out a massive downturn and sticking to your strategy. That’s a pretty awesome result for a very simple system!

You Have to Pay The Piper

​Of course every system has its shortfalls. In the case of asset allocation, you pay for your downside protection by lagging an all-stock portfolio during rising markets. By carrying a chunk of low yielding bonds in today’s environment, you underperform common stock benchmarks such as the S&P. This is also the case where simple doesn’t mean easy. It can be very psychologically difficult to see stocks rise faster than your portfolio. The fear of missing out can become the greatest after a long bull run. At times like these, it is important to keep in mind that this is the price we pay to have the ability to take advantage of market pullbacks. Continually selling portions of appreciating assets allows us to build the “dry powder” that we can put to use during the next market sell off.
 
This example is a very simple illustration. It shows that following a disciplined asset allocation and rebalancing system has several big advantages: 1) It allows us appropriately match our risk tolerance in advance. 2) It defines the actions we must take to manage our portfolio over time 3) It allows us to benefit from market drawdowns.
 
If you are like me, you will agree this makes it a pretty beautiful system.