This is a timely repost from last year. Sharp downturns are always a good reminder that our financial theories might not always align with our financial reality. As I like to say, if you don’t get your risk profile right at the start, the market will teach it to you at some point. Knowing your max pain point is a crucial part of good portfolio management.
My biggest gripe with Modern Portfolio Theory is that it tends to lead investors into very stock heavy portfolios. The thinking usually goes something like this:
Stocks tend to go up over the long-term which means if you are somewhat young then you can afford to ride out the higher volatility of stocks and allocate your assets in a stock heavy portfolio.
I’m oversimplifying things, but not by much. I view people’s portfolios as being a literal “savings portfolio”. I actually hate the word “investing” as it’s applied in Modern Finance. The reason why is because I think this mentality tends to lead people to take much more risk with their savings than they’re often comfortable with. They reach for return instead of balancing the risk of permanent loss risk relative to purchasing power risk.
To make matters worse a stock heavy portfolio is actually much more stock heavy than the allocation often implies. For instance, a 60/40 portfolio is actually more like a 80/20 portfolio because the majority of the permanent loss risk comes from the 60% stock piece. 60/40 isn’t nearly as balanced as some people think.
Understanding how this applies to someone’s risk profile and allocation is not always easy. I always say that if you don’t get your risk profile right at the start the market will eventually teach it to you. And that’s the biggest problem with the way a lot of people allocate assets using Modern Portfolio Theory. The idea of the “long-term” is statistically sound except for the fact that most people have relatively short-term financial lives. And it’s times like these that we realize that having our savings fully or mostly invested in the stock market can be a bit more uncomfortable than theory leads us to believe. Balancing the multi-temporal nature of the stock market and someone’s financial life is very difficult.
The problem is, using Modern Portfolio Theory, most people will tend to be vastly overweight the risk of purchasing power protection relative to permanent loss protection when my experience is that most people have a much stronger aversion of permanent loss risk than a standard MPT allocation implies. One good way to test this view is to ask yourself what your max pain point is. Pretend you have your entire net worth invested in stocks and they fall by 50% in one year. Can you stomach that sort of a loss even if you know they’ll likely rebound in the next 5-10 years? Or is your max pain point much lower? Is it 25%? 15%? 5%?
You would never want to construct your portfolio around worst case scenarios, but you should always stress test a portfolio against worst case scenarios. A lot of people are finding out right now that their max pain point is much lower than their initial allocations led them to believe. And they’re reacting in precisely the wrong way as a result. They’re selling low after buying high. Knowing your max pain point is essential to smart asset allocation. After all, if you don’t know your max pain point going into inevitable market declines like the current one then the market will teach you what that max pain point is at some point. It’s always smarter to know going in than to find out after the fact.