A picture, as the saying goes, is worth a thousand words. Over the years, I’ve found certain images and illustrations to be immensely helpful in discussing investment concepts. These are the ones I’ve relied on most:
Only in Australia. A key challenge for investors—if not the key challenge—is that none of us has a crystal ball. It’s impossible to know what markets will do next month or next year. As a result, all we’re left with is our best guess, and for that reason, it’s natural to extrapolate from recent history. The problem, though, is that there’s a first time for everything. So we can never be too confident that something won’t happen just because it hasn’t happened before, or because it hasn’t happened recently.
This concept was best illustrated by author and retired investor Nassim Nicholas Taleb in his book The Black Swan. In most parts of the world, including the United States, swans are white. But not everywhere. In Australia, for example, most swans are black. But if you’d never been there, and if every single swan you’d ever seen was white, you might feel safe in concluding that all swans are white. The lesson: Don’t dismiss risks, or possibilities, out of hand just because they seem unlikely.
In a new home. Suppose you were furnishing a new home. How would you go about it? If you’re like most people, you’d start with the basics—a table and chairs for the kitchen, a couch for the living room, and so forth. You probably would not, however, start by purchasing an umbrella stand. That would be nonsensical. But that’s the way the investment industry markets mutual funds to consumers. Open Money magazine or similar publications, and you’ll see ads promoting all sorts of different funds—everything from stocks to gold to cryptocurrency. As a result, many people start out their investing careers by assembling a collection of investments without an overall blueprint—like buying an umbrella stand before anything else. A better way: Try to tune out Wall Street’s marketing and instead think about building your portfolio the same way you’d build a home: with an overall plan as your first step.
In the war chest. When it comes to asset allocation, it’s common to think in percentage terms. You might ask whether you should have 50% or 60% in stocks, for example. While that makes sense, I also recommend thinking in dollar terms—specifically, the amount of dollars you hold outside of stocks. Suppose you’re in retirement and require $100,000 per year from your portfolio. Then as an asset allocation, I might suggest holding $500,000 or $700,000 in a combination of cash and bonds. Because those are the dollars that would help carry you through a stock market downturn, I wouldn’t worry too much what that would translate to in percentage terms. I view the percentage as secondary. Fellow financial planner Matthew Jarvis calls these cash-and-bond dollars a “war chest,” and I think that’s an excellent image.
In the studio. Pablo Picasso was obviously very productive, but the state of his studio might have led you to think otherwise. It was a mess. Among the canvases was an assortment of cats and dogs, as well as a monkey that liked to sit on the artist’s shoulder as he worked. But a lot of good work emerged from that chaos. The lesson for investors: You don’t need to get everything right. Instead, know what’s most important, then focus your energy on getting the basics right.
On the elevator. Mutual funds make it easy for investors to build diversified portfolios. But they’re not perfect. A key flaw is that a fund’s gains or losses are shared pro rata by all of its shareholders. Normally this isn’t an issue, but in market downturns it can be a problem. That’s because downturns will always cause some investors to become spooked. If enough shareholders request redemptions from a fund, it can cause the fund manager to sell holdings, triggering a tax impact for every other shareholder. That’s why I compare being an investor in a mutual fund to being a passenger on an elevator: Everything will probably be just fine—as long as everybody else behaves. But since the world is unpredictable, I try to minimize that risk by sticking to exchange-traded funds (ETFs), and especially to index-based ETFs, which are structured in a way that lends themselves to being more tax-efficient.
On the farm. I’ve often quoted what I believe to be the only published poem in the world of personal finance. In 1938, John Burr Williams included these words in an otherwise math-filled volume called The Theory of Investment Value:
A cow for her milk
A hen for her eggs
An orchard for its fruit
Bees for their honey
Williams used this image to illustrate a key concept in finance: intrinsic value. The idea is that an investment only has value because it can produce something. Stocks, for example, can produce dividends. Bonds produce interest. Real estate produces rent. That’s why I avoid things like cryptocurrency, which might be interesting but carry no intrinsic value. The risk: Assets lacking in intrinsic value are worth only what the next person is willing to pay for them. That makes their prices more volatile and unpredictable.
In the diamond. Warren Buffett has offered his own colorful illustration of intrinsic value. If you took all of the world’s gold, he’s said, it would form a cube about 67 feet high. It would fill most of a baseball diamond. That might seem valuable, but what would it do for you? Buffett says, “You could get a ladder and climb on top of it…you could polish it…you could stare at it…but it isn’t going to do anything.” In other words, gold, unlike stocks or bonds, doesn’t produce dividends or interest. “All you’re doing when you buy that is hoping that somebody else…will pay you more to own something that, again, can’t do anything.” While gold is a bit of a special case because of its long history, the point remains. If an investment isn’t capable of producing any income until you sell it to someone else, it’s going to be inherently more risky and its value more subjective.
At home. In recent weeks, I’ve discussed the risk posed by hackers, and that’s one of the reasons I recommend not holding all your assets at the same institution. That said, I do recommend consolidating most of your assets under the same roof. Here’s how I think about it: Suppose you’re babysitting two children. To keep things under control, it’s best if they’re both within your line of sight. But if one is playing in the yard, and the other is running around in the basement, anything could happen. It’s the same with your portfolio. The fewer places you have to look to keep tabs on things, the easier it will be to more effectively monitor your portfolio and to make changes.
On the road. Some years ago, I was heading to a meeting in upstate New York. At a certain point, I realized I was going too fast, and for no good reason. If I slowed down, I still would’ve gotten there on time. But if I’d gotten pulled over, then I would’ve ended up being late. It’s the same with asset allocation. We all want our investments to grow. But if we hold too much in stocks, it can end up backfiring. Sometimes it’s better to slow down a little, to avoid getting derailed.
Running away. Groucho Marx famously said, “I don’t want to belong to any club that would accept me as one of its members.” Years later, venture capitalist Andy Rachleff offered investors advice along the same lines. The most successful venture capital, private equity and hedge funds, Rachleff explained, have no shortage of investors such as university endowments willing to write eight- or nine-figure checks. It’s only investment funds with poor track records that are out marketing their funds to individual investors. So if you’re on the receiving end of a pitch like this, Rachleff says, “run away.”