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Do We Implement Portfolio Construction Completely Backwards?

I’ve had three big investing epiphanies in my investing career.

The first big epiphany was that macro matters much more than micro. The direction of the river is much more important than the strength of the swimmer. Anyone can float down a river, but trying to fight the current is often a losing battle.

Back in the early 2000’s I used to run a stock picking strategy that unknowingly took advantage of the “overnight effect” in stocks. I generated very high returns during a period when the S&P 500 was flat, but the strategy completely stopped working in 2008 when the financial crisis occurred. I thought I was a genius for many years, but one of the smartest things I ever discovered was that…I am not that smart.

It was at this time that I realized the importance of macro investing and especially the importance of understanding the Fed, Treasury and the entities that can influence the direction and speed of the river. Trying to swim against the Fed’s tide is a losing battle.

This is the main reason I turned into more of an indexer over time. Stock picking works great when the tide is steady, but when the tide shifts or picks up you can quickly find yourself in a bad spot.

The second big epihpany was when I was writing my book and better developed the concept of saving vs investing as it relates to economics and finance. I realized that the term “investing” is used, almost universally, in an erroneous manner. That is, true investing is spending, not consumed, for future production and it’s done mostly by corporations. Most of the stuff we call investing (like buying stocks) is not actually investing at all. It’s reallocation of savings and the value of that savings changes based on how companies invest. It’s a subtle but important distinction because treating your portfolio like a sexy get rich “investing” portfolio is a very different mentality from treating your portfolio like your savings. And that’s literally what most of us are doing – we’re reallocating our life’s savings. But Wall Street wants us to think we’re sexy investors who need to “beat the market” trading a lot or paying high fees to investment managers to do it for us.

No, most of us would be a lot better off if we stopped treating our portfolios like short-term gambling accounts and treated them more like prudent savings portfolios.

The third big epiphany was rather recent and occurred when I calculated the “durations” of all the different asset classes while I was writing my All Duration paper. My experience is that most people would be much better investors if they had a better understanding of the time horizons of their investments. Instead, we tend to succumb to the aforementioned “investing” myth and we mistreat our savings by doing all sorts of counterproductive short-term things. This is understandable because we can’t know the exact time horizon of something like the S&P 500. So we often judge the stock market over a monthly or annual time period, but the stock market is not a one month or one year instrument. In my All Duration model it’s roughly equivalent to an 18 year instrument. Of course, that will never be a precise measurement like a bond’s duration, but it at least provides us with a more practical perspective of the expected time horizon.

This third epiphany was especially eye opening to me because it’s a very different framework for asset allocation. In traditional portfolio management such as a Modern Portfolio Theory approach you generally try to build the most efficient asset allocation. So, you run a bunch of backtests, cherry pick historical data and implement some monte carlo simulations and then you slap together the portfolio that fits the efficient frontier or whatever the best risk adjusted return is. You might arrive at something like 60/40 stocks/bonds and then you fit that portfolio to a risk profile and tell yourself to ride out all the ups and downs. I’ve done this my entire career and so does the rest of the financial services industry. But this is a backwards way of doing things!

The All Duration approach is the exact opposite. What you do first is find someone’s liabilities across different time horizons. And then you apply the appropriate assets based on those liabilities. If it ends up looking like something on the efficient frontier then great. But the goal isn’t to create the most efficient overall portfolio or the market beating portfolio. The goal is to efficiently match assets with certain liabilities so the investor has greater certainty about their assets relative to their future liabilities. This not only helps them meet their financial obligations across time, but it helps them build a more behaviorally robust portfolio by giving the investor greater perspective and certainty about how much money they’re likely to have for specific financial needs in the future.

This form of asset-liability matching takes more of a prudent and frankly, common sense approach to asset allocation by establishing the portfolio you NEED and not the portfolio you WANT. After all, it’s usually chasing the portfolio you want that makes you realize what you need. And unfortunately, most of us don’t realize, until it’s too late, that chasing the portfolio we WANT is really just chasing risk we don’t want.

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