A positive aspect of the current COVID-19 lockdown is we have more time to revisit a few tasks and pleasures which we would otherwise put on the back burner. For you, it might be re-reading a favourite book.
In 2001, Nassim Taleb published Fooled by Randomness which compares the wealth of a dentist to a wealthier Wall Street trader.
The trader makes more money and lives in a larger house than the dentist, yet on an ‘expected’ basis, the dentist is wealthier. If you re-ran the earnings from a dental practice over many alternative lives, each would be similar (teeth need to be looked after).
The product of the outcome and the probability reflects the dentist’s ‘expected’ wealth, which is fairly consistent and is divorced from randomness to a large extent.
Meanwhile, the trader’s wealth represents the spoils of a life which is the outcome of randomness. It hides the left tail risk of complete disaster (e.g. losing a lot of client money, getting fired, defaulting on a mortgage).
On this basis, the dentist’s wealth makes them richer.
Taleb uses the analogy of playing Russian roulette. Deer Hunter viewers will know it is likely to end in tragedy. Many investors play Russian roulette in their investment lives, albeit with a revolver with far more empty chambers.
At some point, the deadly chamber will end up against the pin, with disastrous portfolio outcomes. Yet the rarity of this event means it is often ignored. In the meantime though, your investment life may be rewarding.
From an investment portfolio perspective, you can’t use the lens of your own single life past returns with 20/20 hindsight.
Instead, it requires a lens looking at ‘expected’ outcomes and the chances of them occurring. You should ask yourself a key question: over multiple lives, has the expected outcome of a portfolio structure been higher than the expected outcome of another alternative portfolio strategy?
You can put a value (gain or loss) on the decisions you made in your life. The classic car, the holiday home in Cornwall, the decision to fund a start-up business. Not difficult.
But what is difficult to do and rarely done is calculating the gain or loss from the alternative choices.
Avoiding the bullets
There can be much variation in the investment weather you experience. One goal of constructing a good portfolio is to cover all the bases.
In structuring a portfolio, you should seek to avoid the single left-tail bullets, as these result in the cardinal sin of investing; permanent loss of capital.
Amongst these bullets are:
- Concentration risk (e.g. too much money in any one company).
- Liquidity mismatches (e.g. brick and mortar property funds).
- Low-quality bonds (default risk) and active manager risks (e.g. Woodford).
- Non-UCITs products and opaque investment strategies, to name a few.
Structural robustness can be provided by a combination of a diversified global equity core across markets, sectors, and companies, balanced against higher-quality bonds.
Figure 1. Ensuring that expected outcomes are likely to be positive.
As Taleb states,
“One can't judge 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 differently).”
Not all investment portfolios in the UK are like this. It is also uncommon to have a low-cost, well-diversified, evidence-based strategy designed to match your future needs.
This is another benefit of the COVID-19 lockdown. Take a deep, hard look at your investment portfolio. If you aren’t confident you know what to look for, get a second opinion from an expert.
The longer-term horizon of most investors, in combination with a diversified portfolio which excludes key sources of permanent capital loss, makes them well-positioned to navigate the future.
It may be less glamorous to peer into people’s mouths for a living than to be the Wolf of Wall Street, but it will likely pay higher dividends over time.