MONEY Master the Game: 7 Simple Steps to Financial Freedom (59 page)

RISKY BUSINESS

By dividing up your money in 50% stocks and 50% bonds (or some general variation thereof), many would think that they are diversified and spreading out their risk.
But in reality, you really are taking much more risk than you think.
Why? Because, as Ray pointed out emphatically multiple times during our conversation,
stocks are
three times
more risky (aka volatile) than bonds.

“Tony, by having a fifty-fifty portfolio, you really have more like ninety-five percent of your risk in stocks!”
Below is a pie chart of the 50/50 portfolio. The left side shows how the money is divided up between stocks and bonds
in percentage terms.
But the right side shows how the same portfolio is divided up
in terms of risk.

So with 50% of your “money” in stocks, it
seems
relatively balanced at first glance. But as shown here, you would have closer to 95% or more at “risk” because of the size and volatility of your stock holdings. Thus, if stocks tank, the whole portfolio tanks. So much for balance!

How does this concept translate to real life?

From 1973 through 2013, the S&P 500 has lost money nine times, and the cumulative losses totaled 134%! During the same period, bonds (represented by the Barclays Aggregate Bond index) lost money just three times, and the cumulative losses were just 6%. So if you had a 50/50 portfolio, the S&P 500 accounted for over 95% of your losses!

“Tony,”
Ray said,
“when you look at most portfolios, they have a very strong bias to do well in good times and bad in bad times.”
And thus your de facto strategy is simply
hoping
that stocks go up. This conventional approach to diversifying investments isn’t diversifying at all.

I had never heard this concept of balance versus risk explained so simply. As I sat there, I started to think back to my own investments and where I may have made some wrong assumptions.

So let me ask you, how does this understanding make you feel about your “balanced” portfolio now?

Does this change your view as to what it means to be diversified? I sure hope so! Most people try to protect themselves by diversifying the
amount of money
they put into certain investment assets. One might say, “Fifty percent of my money is in ‘risky’ stocks (with perhaps greater upside potential if things go well) and fifty percent of my money is going in ‘secure’ bonds to protect me.” Ray is showing us that if your money is divided equally, yet your investments are not equal in their risk, you are not balanced! You are really still putting most of your money at risk! You have to divide up your money based on how much risk/reward there is—not just in equal amounts of dollars in each type of investment.

You now know something that 99% of investors don’t know and that most professionals don’t know or implement! But don’t feel bad. Ray says most of the big institutions, with hundreds of billions of dollars, are making the same mistake!

RAINMAKER

Ray was now on a roll and was systematically dissecting everything I had been taught or sold over the years!

“Tony, there is another major problem with the balanced portfolio ‘theory.’ It’s based around a giant and, unfortunately, inaccurate assumption. It’s the difference between correlation and causation.”

Correlation
is a fancy investment word for when things move together. In primitive cultures, they would dance in an attempt to make it rain. Sometimes it actually worked! Or so they thought. They confused
causation
with
correlation.
In other words, they thought their jumping up and down
caused
the rain, but it was actually just coincidence. And if it happened more and more often, they would build some false confidence around their ability to predict the
correlation
between their dancing and the rain.

Investment professionals often buy into the same mythology. They say that certain investments are either correlated (move together) or uncorrelated (have no predictable relationship). And yes, at times they might be correlated, but like the rainmaker, it’s often just happenstance.

Ray and his team have shown that all historical data point to the fact that many investments have completely random correlations. The 2008 economic collapse destroyed this glaring assumption when almost all asset classes plummeted in unison. The truth is, sometimes they move together, sometimes they don’t. So when the professionals try to create balance, hoping stocks move in the opposite direction of bonds, for example, it’s a complete crapshoot. But this faulty logic is the underpinning of what most financial professionals use as their “true north.”

Ray has clearly uncovered some glaring holes in the traditional asset allocation model.
If he were a professor at an Ivy League school and had published this work, he probably would have been nominated for a Nobel Prize! But in the trenches—in the jungle—is where Ray would rather live.

THE FOUR SEASONS

When I talked with David Swensen, Yale’s chief investment officer, he told me that
“unconventional wisdom is the only way you can succeed.”
Follow the herd, and you don’t have a chance. Oftentimes people hear the same
advice or thinking over and over again and mistake it for the truth. But it’s unconventional wisdom that usually leads to the truth and more often leads to a competitive advantage.

And here is where Ray’s second piece of unconventional wisdom came crashing in. “Tony, when looking back through history,
there is one thing we can see with absolute certainty: every investment has an ideal environment in which it flourishes. In other words, there’s a season for everything.
”

Take real estate, for example. Look back to the early 2000s, when Americans were buying whatever they could get their hands on (including people with little money!). But they weren’t just buying homes because “interest rates were low.” Interest rates were even lower in 2009, and they couldn’t give houses away. People were buying during the boom because prices were inflating rapidly. Home prices were rising every single month, and they didn’t want to miss out. Billionaire investing icon George Soros pointed out that “Americans have added more household mortgage debt in the last six years [by 2007] than in the prior life of the mortgage market.” That’s right, more loans were issued in six years than in the entire history of home loans.

In Miami and many parts of South Florida, you could put down a deposit, and because of inflationary prices, before the condo was even finished being built, you could sell it for a sizeable profit. And what did people do with that home equity? They used their home like an ATM and spent it, and that massive spending stimulated the profitability of corporations and the growth of the economy. Soros cited some staggering numbers: “Martin Feldstein, a former chairman of the Council of Economic Advisers,
estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity.”
To put this in perspective, in just six years (from 2001 to 2007), Americans added more household mortgage debt
(about $5.5 trillion)
than in the prior life of the mortgage market, which is more than a century old. Of course, this national behavior is not a sustainable way to live. When home prices dropped like a rock, so did spending and the economy.

In summary, which season or environment can powerfully drive home prices? Inflation. But in 2009 we experienced
de
flation, when prices sank, and many mortage holders were left with a home underwater—worth less than what they owed. Deflation drops the price of this investment class.

How about stocks? They too perform well during inflation. With
inflation comes rising prices. Higher prices mean that companies have the opportunity to make more money. And rising revenues mean growth in stock prices. This has proven true over time.

Bonds are a different animal. Take US Treasury bonds, for example. If we have a season of deflation, which is accompanied by falling interest rates, bond prices will rise.

Ray then revealed the most simple and important distinction of all. There are only four things that move the price of assets:

1. inflation,

2. deflation,

3. rising economic growth, and

4. declining economic growth.

Ray’s view boils it down to only four different possible environments, or economic seasons, that will ultimately affect whether investments (asset prices) go up or down. (Except unlike nature, there is not a predetermined order in which the seasons will arrive.) They are:

1. higher than expected inflation (rising prices),

2. lower than expected inflation (or deflation),

3. higher than expected economic growth, and

4. lower than expected economic growth.

When you look at a stock (or bond) price today, the price already incorporates what we (the market) “expect” about the future. Ray said to me, “Tony, there is a literal picture of the future when you look at prices today.” In other words, the price of Apple’s stock today incorporates the
expectations
of investors who believe the company will continue to grow at a certain pace. This is why you may have heard that a stock will fall when a company says that its future growth (earnings) will be lower than it had initially expected.

“It’s the
surprises
that will ultimately determine which asset class will do well. If we have a real good growth surprise, that would be very good for stocks and not great for bonds. For bonds, if we have a surprise drop in inflation, it would be good for bonds.”

If there are only four potential economic environments or seasons, Ray says you should have 25% of your
risk
in each of these four categories. He explains: “I know that there are good and bad environments for all asset classes. And I know that in one’s lifetime, there will be a ruinous environment for one of those asset classes. That’s been true throughout history.”

This is why he calls this approach All Weather: because there are four possible seasons in the financial world, and nobody really knows which season will come next. With this approach, each season, each quadrant, is covered all the time, so you’re always protected. Ray elaborates:
“I imagine four portfolios, each with an equal amount of risk in them. That means I would not have an exposure to any particular environment.”
How cool is that? We aren’t trying to predict the future, because nobody knows what the future holds. What we do know is that there only four potential seasons we will all face. By using this investment strategy, we can know that we are protected—not merely hoping—and that our investments are sheltered and will do well in any season that comes our way.

Bob Prince, the co-chief investment officer at Bridgewater, describes the uniqueness of the All Weather approach:
“Today we can structure a portfolio that will do well in 2022, even though we can’t possibly know what the world will look like in 2022.”

I honestly sat there with my jaw open because nobody had ever described to me such a simple yet elegant solution. It makes perfect sense to have
investments, divided up equally by risk, that will do well in all seasons but
how
you actually accomplish this is the golden ticket.

“So we know the four potential seasons, but which type of investment will perform well in each of these environments?” Ray responded by categorizing them into each season. Below is a chart that makes it easy to break down visually.