In the Nature of True Wealth Management essay, we identified three of its attributes: Living Our Lives with Confidence, Dollars of Future Wealth, and Avoiding Unnecessary Risk. Before discussing the latter, it helps to identify some different kinds of risk.
Nearly every traditional investment forecast is a combination of these: interest rate, inflation, market, currency, business, political, economic or headline risk. One thing they have in common is that their potential impact is already included in the prices of liquid securities. Another common trait is that no investor or committee of experts can predict or control any of them.
Even more amazing - while some investment strategists claim some kind of superior forecasting skills, most of them do not discuss the two risks we can actually control or anticipate. These essential factors are underperformance risk and cash flow/sequence of return risk. They can be ignored because it would likely render the investment strategists irrelevant.
The traditional industry value proposition is rooted in finding mispriced securities, mispriced industry sectors, or mispriced asset classes. Nearly half the time, the good ones are right. Yet this ignores the obvious question: how much additional risk was taken for their opportunity to underperform?
At Affluent Capital, one of our advisors' steadfast principles is to control what we can control. At the top of the list is risk exposure - how much to invest in risk assets like stocks, and balance that with other factors we control such as savings habits, spending goals, and financial resources.
In the movie Moneyball, Oakland Athletics GM Billy Beane did the same thing. He evaluated baseball talent based on the statistics a player could control. For example, he discovered that a pitcher’s ability could be discovered by home runs allowed, strikeouts won, and walks. Traditional metrics like Earned Run Average, Batting Average, and Wins became irrelevant. Beane replaced them with On Base Percentage.
At Affluent Capital, our advisors evaluate talent based on the factors that a money manager can control - the ones relevant to our client’s success. At the top of the list are correlation to the broad market asset classes we want to own and expense ratios. Selection of asset classes is also key - they must have long and reliable historical data sets for correlation, median return, and standard deviation.
These three metrics are also potential assumption errors, are included in every asset class, and inherent to Efficient Market Theory. Yet traditional “best practices” include multiple “alternative” asset classes for its so-called diversification.
Not only does each one of these add three more potential assumption errors, in extreme markets they can correlate almost perfectly with the risk assets (stocks) they are supposed to diversify.
Moneyball teaches us that pitchers have one job – get the batter to swing at bad pitches. It also teaches that batters have one job – do not swing at bad pitches! At Affluent Capital, our advisors do not swing at the alternative, sector, forecast, outperformance, social, or technical bad pitches. Instead, we respect the price mechanism of free markets and take control of our futures.
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The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Neither asset allocation nor diversification guarantee a profit or protect against a loss. There is no guarantee that any strategies discussed will result in a positive outcome.
Standard deviation is a statistical measure of the range of performance in which the total returns of an investment will fall. When an investment has a high standard deviation, the range of performance is very wide, indicating that there is a greater potential for volatility. "Market efficiency refers to the degree to which market prices reflect all available, relevant information" (investopedia.com)