Harold Evensky: Good morning, class.
Class: Good morning, Professor Evensky.
Andrew: Professor Evensky, why are you carrying that umbrella? The temperature outside is 110 degrees and it hasn’t rained in the past three months!
HE: Andrew, that’s an excellent question. And this umbrella is what we call a prop. It will help introduce one of the most important issues in wealth management: diversification and asset allocation, and why they’re so important in helping our clients meet their goals.
Elizabeth: Professor Evensky, will this be on the test?
HE: So I’ve prepared a little exercise to help all of us think through how to make investment recommendations in light of client goals. Is everybody ready?
HE: In this exercise, our clients live in a simple world where they have a choice of only three investments. Two of them are risky. I’ll write the choices here on the whiteboard:
HE: Everybody got that? As a sophisticated planner, you recognize that the swimsuit and umbrella company stocks are very risky, since an investor will either make a great return or no return, depending on the weather. So you’ve consulted with some of the world’s greatest meteorologists and arrived at the following:
80 percent probability that it will be rainy 90 percent of the time
60 percent probability that it will be rainy 70 percent of the time
30 percent probability that it will be rainy only 20 percent of the time
How would you recommend my clients allocate their investments? Where do you start?
Andrew: Well, you say we should always start with what we know about our clients.
HE: Great start, Andrew. And what important things do we know about them?
Andrew: To achieve their goals, they need at least a 10 percent return. We also know they are not very tolerant of investment volatility. They don’t like their investments to bounce around a lot.
HE: Good so far. Kiran, where does that take us?
Kiran: Only now should we look at the investments. We should look at the possible investment outcomes—which, in this case, seem to depend on the weather.
Nicholas: Professor Evensky, while everybody else was chattering on about the clients, I made up a little table that shows all the different possible portfolio returns based on the weather data you gave us.
HE: Thank you, Nicholas.
Nicholas: I also created a neat little algorithm that will do these same calculations if we ever run into a problem like this again. I could show you after class.
HE: Nicholas, I’m going to go out on a limb and predict that you have a bright future as an investment analyst.
Nicholas: Whatever. Wait. That doesn’t mean I’ll have to talk to actual people, does it?
Carly: Professor Evensky, I’ll check Nicholas’s math.
HE: Thank you, Carly. So does everybody see where the numbers come from?
Suppose, for example, you have 90 percent allocated to umbrellas and it rains 70 percent of the time. That means you will profit from all of the 70 percent rainy days. That’s a net of 14 percent to 20 percent, maximum, times 70 percent, right, Nicholas?
HE: Okay, now let’s consider how we did with our swimsuit company investment. Since only 10 percent is invested in the swimsuit company, and there are 30 percent sunny days, the swimsuit company can profit from only some of those sunny days. So my return is 20 percent, maximum, times the 10 percent I have invested in swimsuits, which equals 2 percent. Add 2 percent return from swimsuits to 14 percent return from umbrellas, and you get a total of 16 percent. If this turns out to be the real weather pattern, I didn’t get the full 20 percent because I owned too many umbrellas and not enough swimsuits.
Kiran: And that’s where all the other possibilities came from?
HE: Correct. You can use the same process to calculate the other figures in the chart. So now what? Do you have an answer to the proper allocation for these clients who need 10 percent a year and don’t like a lot of volatility?
Alicia: Well, I guess we have to toss out the safe investment.
HE: Good, Alicia. Why?
Alicia: At a fixed 8 percent, the CD is a nonstarter. For someone who needs 10 percent, only receiving 8 percent, no matter how guaranteed, would be a failure.
HE: Good thinking. Of course, when you present the alternatives, our client might elect to revise the goals so that 8 percent would suffice. But before we recommend that, let’s look at the risky alternatives. What do you see here?
Kiran: I’d apply Modern Portfolio Theory, and come up with a blend of the risky investments. If you blend investments that respond differently to different investment climates, then the result is a portfolio with less volatility.
HE: Very good. And did y’all get my joke? Investment climate—rain or sun—pretty funny, right?
Kiran: Professor Evensky, maybe you shouldn’t try to be funny in class.
HE: Yes, well, the important thing is that we can blend these risky investments. And in this simplified investment world we’ve created, what do you notice immediately?
Alicia: The risk and return patterns are exactly the opposite. You make money in swimsuits when it’s sunny, and when it rains, your return comes from umbrellas. It either rains or it doesn’t.
HE: Right. So?
Alicia: So in that simplified investment world, if we put half in swimsuits and half in umbrellas, we’d always be making 20 percent on half of our portfolio and 0 percent on the other half.
Andrew: For these clients, if they invest half of their money in swimsuits and half in umbrellas, no matter what happens, even if it never rains again or the deluge never ends, or anything in between, the clients will get a guaranteed 10 percent return—which is exactly what the client needs.
HE: Excellent. Of course, in the real world, you probably have thousands of different drivers of the profits of tens of thousands of different companies. If you were to bet on any one of them, there’s the possibility that whatever you were betting on, just the opposite would happen and you could lose a lot of money. But if you spread your bets around, and the economy grows—which it has done since people were living in caves—then all of those bets across all of those different drivers will smooth out some of the ups and downs. And there’s a high probability, based on history, that your clients will get returns commensurate with their willingness to wade into the world of market risk. Diversification really works.
Kiran: But there’s still risk, right?
HE: Of course. The moral here is not that you can eliminate risk; but in designing your portfolio and evaluating risk, you need to consider the risk of the combined investments, not the risk of each individual investment. And let’s not miss something equally important: you need to consider the risk of not achieving your goals by confusing certainty and safety. Does everybody get it?
Class: Yes, Professor Evensky.
HE: And yes, Elizabeth, this will be on the test.
Elizabeth: What’s that?
HE: But I wanted to get back to something we talked about earlier. Who thought that my investment climate joke was funny? And try to keep in mind that your grade might depend on it.
This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.