In the main episode, we covered asset allocation over the lifecycle with considerations for financial and behavioral risk. These cases walk through the hypothetical experiences of two investors to highlight how real life and real money interacts with asset allocation decisions.
The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor.
Case 1: A plastic surgeon in 1997 with a high risk tolerance who, in addition to a busy practice, offers consulting to the medical technology industry.
Case 2: A business owner in 2019 who sold their company for a large sum recently and doesn’t want to mess up their windfall.
Transcript
- Introduction
- Case 1: A plastic surgeon in 1997 with a high risk tolerance who, in addition to a busy practice, offers consulting to the medical technology industry.
- Case 2: A business owner in 2019 who sold their company for a large sum recently and doesn’t want to mess up their windfall.
Introduction
[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[0:00:17] BF: This is our third Case Conference supplemental episode. We hope that you’re
finding these useful. The cases we’re going to talk about today are based on common scenarios
that often lead people to make poor decisions with their investments. The idea is that you’ll
consider how these situations apply to you, and our guidance to the hypothetical scenarios are
not specific advice, but we hope that you can relate the aspect of them and use that in your own
thinking or with your financial advisor.
[0:00:42] MS: Yes. We spent a lot of time in the main episode talking about choosing an asset allocation that suits your risk tolerance. So, what we’re going to do with our cases today is we thought we’d take you through the experience of a few different investors during some challenging periods of recent market history, and just use that to illustrate some key points. We’ve got two different investors. Investor one is going to be a plastic surgeon in 1997, who has a high-risk tolerance, in addition to their busy practice. They also do some consulting to the medical technology industry. Then, the second case is going to be a business owner in 2019, and they sold their company for a large sum. They don’t want to mess up their windfall.
Case 1: A plastic surgeon in 1997 with a high risk tolerance who, in addition to a busy practice, offers consulting to the medical technology industry.
[0:01:21] BF: All right, so for our plastic surgeon, they’ve got a large private cosmetic surgery clinic. They have a high income, and they also feel like they’re in tune with tech, because they do some consulting with the MedTech industry. They can see why, they get why stock prices are as high as they are. I think they’re justified at those levels, which was that was pretty common thinking then that there was a new paradigm, and that price-earnings ratios should be as high as they were.
The surgeon’s practice is going really well. They have a ton of cash flow way in excess of their living expenses, which are high, and they want to start investing. They assess their own ability to take risks as high based on their income, and they feel like they’re comfortable with risk. They know that they want to achieve financial independence as quickly as possible. Mark, if you ran into the surgeon in the hallway, and they asked you what they should do, what would you tell them?
Human Capital, Financial Capital, and Overconfidence
[0:02:12] MS: So, this is back in 1997. But I’ve actually met many different versions of this surgeon. I mean, both with the surgeons and non-surgical physicians and in this case, with this plastic surgeon in a big private practice, they are going to have a significant amount of money concentrated in their practice. It takes a lot to run that type of business. Many physician practices are pretty recession-proof, but they’ve got a large cosmetic surgery component that could be cyclical to a degree. So, they should invest outside of their clinic as well to be more diversified.
Now, they feel that they have this high emotional risk tolerance and a high cash flow, that’s great. So, they have a good ability to take on risk, and they certainly sound they’re willing to take on risk. However, with their high cash flow relative to their spending, they also have a bit less need to take on risk, using the framework of ability, willingness, and need. Plus, I think there’s also some risks in their practice that they may have under-appreciated.
It’s also common to extrapolate your expertise and success in your business to other areas, the tech industry in this case. And even if you do understand the science of medical technology, which this physician probably does, the business of bringing that technology to market and then making it profitable, is actually an entirely different story from the science. They’re not the same thing. I mean, my advice would be to focus their energy on growing their practice, because that’s where being a specialist is helpful. So, specializing and putting your effort into that is going to bear fruit. They can consult in medical technology, because it’s interesting, and who knows, it could pay off.
But outside of that, I would minimize the energy that I was spending trying to make bets in areas of more public markets where they’re likely to not really have any real control and the efficient market is going to be at work there. It’s a different situation.
[0:03:54] BF: Okay. After their conversation with you, they decide they’re going to invest in an aggressive portfolio consisting of US stocks, 90% US stocks, and 10%, high-tech US stocks specifically, so they’re really going to go in on that sector. Now, they started investing in December of 1997. And 1998 goes on to be an incredible year for US stocks which are up 24% and even more so for US tech, which was up 78% in that calendar year. Now, rather than rebalance their portfolio, which in the main episode we talked about as being important as a risk control mechanism., they decided to double down on tech with a loan from their business secured against some of their equipment. So, they borrowed in their business, against their equipment.
Now, this pays off at first, because tech is up another 78% in 1999. That’s two huge years in a row. But their portfolio is also now way overexposed to tech. I don’t think I need to tell anyone what happens next. This is the dot-com bubble or the tech bubble of 2000, whatever you want to call it. Stocks went on to struggle for the next three years, but tech stocks got absolutely hammered. Now, with cosmetic plastic surgery being somewhat cyclical, our surgeon’s income also takes a hit, and they actually had to sell some of their portfolio to stay afloat.
This Time is Always Different
[0:05:10] MS: This is a very human trap to fall into. I mean, there were a number of human biases that play here, and that leads to what really amounts to an extreme concentration of risk, and that’s what we see manifest. I mean, there was recency bias in that run-up in tech stocks that made people believe that will continue. It’s always different this time. There’s some kind of paradigm shift that the old ways of things working are no longer there. So, we can always convince ourselves of that.
To exacerbate that, they also had some early success with that concentrated strategy, and that’s where greed can kick in, and volatility can make us misbehave. This is a good lesson that volatility can make us misbehave when markets go up, too. It’s not just when it goes down. Instead of rebalancing, they concentrated their risk further, by doubling down on the investment, not only by increasing the risk of investment, actually by using a loan against their more stable income stream, which is a way that they were underpinning their ability to take that kind of investment risk, so they affected both at the same time.
The Best Strategy is the One You Can Stick With
[0:06:09] BF: Okay, so in the end, they recover. They recovered from the downturn. They’re able to pay off the loan. The business is still doing okay. They dropped the tech tilt, because they got burned so hard, they just had enough of that. Maybe they learned their lesson there. But they do continue to hold a portfolio of US stocks. So, we talked about the importance of international diversification. They’ve decided to be all US stocks.
In December 2002, they have a little bit less than when they started investing. It’s not actually terrible, all things considered. So, they’re still only in US stocks. They don’t pay a ton of attention to their investments, and things have been going well. It kind of just go up, up, up from 2002, right up until 2008, when we have, of course, the financial crisis. Now, at that time, they look back on the last decade or so since they started investing, and the returns have been effectively flat. While bonds over that same period have had meaningfully positive returns. So, they decide at this point, they had the bad experience to start with the tech bubble, and now they’re looking at their portfolio, and they’ve made no money in a decade.
So, they just decided that, you know what, the risk tolerance isn’t as high as they thought. They decided to switch into a portfolio of 100% bonds, which have done much better over this period. Now, of course, for anyone who’s been paying attention to the financial markets since then, US stocks from 2009 or so until now, effectively, have gone on a historic, incredible, positive run.
[0:07:31] MS: Again, this is a good illustration through this and investors’ experience with some valuable lessons. I mean, one of the things they did is they overestimate their risk tolerance. It’s easy for people to do that when they haven’t actually experienced what that feels like in real life. Then, instead of making an asset allocation based on that risk tolerance and sticking to that, they became reactive to different situations. So, if you don’t make a deliberate plan, you can’t possibly have the discipline to follow it, because you don’t really have a plan. It’s hard enough to follow a plan because you’re a regular human being not living in a vacuum. So, you need to have that plan, and the lack of that caused them to not rebalance. And even worse, they actually doubled down, and then they magnified that using leverage.
I mentioned that was one of the concentrations of risk, and they learned a lesson from that because it heightened over the volatility beyond even the regular amount. Then, when things went sour, they also reacted again in the opposite direction this time. They sold and went to cash, and they were watching from the sidelines, again, as the market subsequently went up over the next 15 years on a big tear. I would bet anything that they also experienced fear of missing out sometime during that bull market that followed the 2008, ’09 period. And at some point, they change asset allocations yet again after having missed out and reacted to that situation.
The Importance of an Investment Policy Statement
So, one way to combat this type of reactive type of behaviour is to not only do a risk assessment and choose an asset allocation, but also to make a written investor policy statement. That would actually include a bunch of important aspects. One of the big aspects would be asset allocation, and also the specific conditions under which you would consider making tweaks to parts of that. Because we did mention, during the main episode that you are possibly going to make adjustments to your asset allocation as you move through life, but you want to not do that reactively. It has to be a deliberate, specified choice that you’re doing that. And you need to be able to follow that investor policy statement. Just having one isn’t enough if you don’t actually use it. That means you’re going to have to have either if you’re DIY investing, you’re going to have to have the discipline and the strong understanding and belief and why you wrote that policy the way it is, so that that belief will stand up in tough situations. If you are using an advisor, that’s another way of doing what the barrier because you’d have to talk to them before hitting the buy and the sell button. Of course, you’d also have to listen to them at the same time.
Know You Risk Exposures Inside and Out
I think the other lesson that’s instrumental in this case is one about human capital and financial assets. They needed to know the risks of their human capital. Their business income, and factor that into the other risks that they were taking. When things are going well, it’s great. But we don’t always know what’s going to happen in the future. I mean, we saw that again and COVID is a great example where suddenly all the ORs shut down for a period of time, and people who still had ongoing overhead and other costs suddenly didn’t have a revenue stream.
There’s all sorts of things we don’t control and we can’t predict that could happen. Even though they did actually still have a good income throughout this time period, they still couldn’t stomach seeing the swings on their investment statements, and factoring in a stable human capital or income stream isn’t much if you can’t think of that when you’re looking at your financial portfolio. You have to be able to take some solace in the fact that you’re earning a good income and all your needs are met. So, the final point, I think, is that risky investments, they can underperform. I mean, it is a risk, and those risks can manifest. This is a real-time period. They can underperform for long time periods. We’ve seen that, many times over history, and this one was flat for – this portfolio was flat for a decade. It was tough for them to stick it out over that decade. You have to be able to stomach holding on to your risky assets for long periods of time, with the help of your safer ones.
[0:11:14] BF: All good lessons. I would maybe even add, we add US stocks in there, and over that same period, I think, that international diversification might have helped a bit.
[0:11:22] MS: Yes. The other parts of the world weren’t hit nearly as hard as the US was. It would’ve blunted that.
Case 2: A business owner in 2019 who sold their company for a large sum recently and doesn’t want to mess up their windfall.
All right, on to our second case. So, this is our business owner. They’re a former business owner who sold their business at a good time, and they now have a lot of cash, and they want to get it invested into the market for the future. They still have a job consulting for the company that bought their business and will keep working, doing that, even though they don’t really need the money. Their expenses are also pretty low. They’re conscious of their risk tolerance being also relatively low. They had been investing in individual stocks when they were younger, and they lost money doing that, and it really kind of left a sour taste in their mouth that’s kind of lingered on and made them afraid of investing that way, because they feel it’s just outside of their control, and they don’t want to mess up the success that they’ve had selling their business now.
So, then what would you tell them if they asked you for your advice?
Ability, Willingness, and Need
[0:12:13] BF: There’s some serious selection bias here because people come to a wealth management firm after they’ve had an event like that. But I have had many conversations with people in very similar situations. There will definitely be a conversation about their objectives and what makes a good life for them. But we can skip that portion of the discussion and assume we’ve kind of figured out what their objectives are. If we think about their ability, willingness, and need to take risks, they certainly have the ability to take risks as they’re financially independent, but they still can earn an income, even if the income is tied to tech.
We know that they think they’re not willing to take much risk because they kind of voiced their views on that in their own risk tolerance. And they don’t need to take risk, since they’re already financially independent. But we also know they really don’t want to mess up this kind of good outcome that they’ve had with selling their business. So, I would definitely emphasize the importance of diversification to avoid any one bad investment permanently reducing their wealth, which is kind of similar to the experience that it sounds like they had when they were younger. They’re also – it sounds like probably averse to volatility, but more so to permanent loss based on their situation.
I might try to have a conversation about the difference between single stock risk and volatility as the relevant risks for their situation, for them to be thinking about when they go through the asset allocation process. They also have low expenses relative to their portfolio, which makes them able to withstand volatility if they can get comfortable with it.
Another interesting comment to make for this case is that since they are financially independent and no longer exposed to risks outside of what happens to their portfolio, like their human capital, they might be able to tilt their portfolio more toward types of stocks that do poorly in recessions. So, they don’t have to worry as much about their human capital being hit with a recession, and then also their portfolio being down at the same time because their human capital is kind of a bonus at this point. They’re able to take more of that risk in their portfolio, whereas somebody relying on their job and concerned about that wouldn’t be able to take that type of risk.
[0:14:10] MS: That kind of covariance type of risk.
[0:14:12] BF: Correct. Yes. A lot more would go into the actual process of figuring this out with the person. But let’s say we 70/30 portfolio.
[0:14:18] MS: All right, great. So, you’d talk to them in December of 2019, which was a good year for markets, and they’re eager to get invested having seen that. How would you get them from cash into their 70/30 portfolio to actually make it work?
Dollar Cost Averaging vs. Lump Sum Investing
[0:14:30] BF: Yes. This is always an interesting conversation. They’ve got to be comfortable with a range of possible outcomes from investing a lump sum, or from dollar cost averaging, which are the kind of the two alternatives. We know that just going ahead and investing a lump sum, so taking all of their capital, investing it right away in their target asset allocation, that’s going to have the best expected outcome. But for a hesitant investor who has more wealth than they need, which in this case, they do. I would be in no rush to convince them to invest a big lump sum on statistical grounds. I think that the behavioural effect of investing a lump sum of cash, right before a market crash can be really challenging, even for an investor who’s in the appropriate asset allocation.
So, since this person is hesitant, and they don’t really need the few extra expected basis points from investing right away, I would probably suggest entering the market systematically with equal investments over the course of 10 or 12 months. That’s the idea of dollar cost averaging.
[0:15:27] MS: So, even though statistically, it’s best thing to bump it in there, that’s actually a pretty risky move, if you turn them off from investing for the future, just by some bad luck. So, it’s not worth it, in this case.
[0:15:39] BF: I’ve seen both. I’ve seen people in this situation who just said, “I’m doing the lump sum.” I’ve even had that happen right before COVID and things went crazy. And in that case, the person was fine. They were not at all concerned. So, I mean, everyone’s going to be different in terms of what they can handle.
[0:15:55] MS: Everyone’s going to be different. I mean, for me having a bunch of cash sitting there would actually bother me. So, I want to just get it over with and out of my sight, into off my list of worries.
Rebalancing Hurts When You Need it Most
Okay. You have this discussion with them. They did disagree with you on taking their time and they go ahead and they invest that lump sum. Of course, soon after COVID does hit and stocks get hammered, value stocks get hammered even more so than the market as a whole. They don’t feel too bad about where their portfolio is, even at the depth of the COVID crash. They’re okay with that. But they’re not happy when you explain that now it would actually be a prudent time to rebalance their portfolio, since it’s now underweight, the stocks, from that big decline in prices. They’d have to go and buy more stocks, essentially. How would you navigate that conversation?
[0:16:40] BF: Yes. So, people do get nervous about rebalancing when markets – well, that’s when you have to rebalance, when markets are choppy. So, stocks tank and all of a sudden, you’ve got to rebalance your portfolio. But that means buying more stocks, which just tanked which can be hard for people to do.
I heard a story from someone who has sat on an investment committee with Harry Markowitz, the man that we mentioned in the main episode that’s kind of responsible for all of modern portfolio theory. So, in the depths of the financial crisis, they had to make this exact decision for a big pool of assets that was representing a whole bunch of investors. Now, nobody knew it was going to happen in the financial crisis, whether stocks would recover, or if this was kind of the beginning of the end. So, Markowitz apparently leaves the room to think and comes back shortly after and explains to everyone that logically, they must rebalance and keep rebalancing. Because if they keep rebalancing, and nobody else does, I guess, they’ll end up buying all the stocks all the way down to zero, and they’ll end up owning the whole market. So, he kind of takes it to its logical conclusion, and he’s like, “We must rebalance.”
Now, that only works with a diversified portfolio, and it does assume that the world doesn’t descend into total anarchy. But I do think it’s a pretty cool model to think about why rebalancing makes sense, even though things do look pretty scary. Now, in this case, in the end, rebalancing into value stocks through COVID ended up being incredible for the people who were able to stick with their asset allocation.
[0:17:59] MS: Yes, it was tough to do. I mean, even when you talk about this and know all about this stuff, it’s hard to actually do it. I know, I was sitting there, and I did it. But it was difficult.
There is one other point to make about that idea that the only real failure from rebalancing into the storm is this descent into anarchy, and I think that actually strengthens the argument, because if you think about that major collapse situation, it probably actually won’t matter what money you have on paper, electronic, if that did happen. I mean, we saw a glimpse of that with the toilet paper hoarding during COVID. I mean, people decide some real asset has utility for whatever the new state of the world is at the time, and that’s what’s going to matter. It’s not going to be some electronic statement or something that doesn’t matter in a world where everything’s broken down. So, I think that just strengthens that argument to keep rebalancing into the pain, because you really actually don’t have anything to lose.
[0:18:49] BF: Yes. I like that. You’re not going to be waiving your brokerage account statement that people –
[0:18:54] MS: No.
[0:18:54] BF: “You don’t understand. Look how much money I have.”
All right, that brings us to the end of our third Case Conference companion episode. These cases are common. These are similar to real conversations that I know you and I’ve had, Mark, but they illustrate the importance of how choosing an asset allocation with a plan, sticking to that plan, and rebalancing. And honestly, considering how it fits with your ability, willingness, and need to take risks.
Related Resources
Rational Reminder Episodes
“Buy the Dip”
Lighting Your Money on Fire with Thematic ETFs
Stock Returns in Recessions (segment)
Loonie Doctor Blog Posts
The material in episode 7 is strongly related to the Investing Basics Module of The Loonie Doctor Core Financial Curriculum. The DIY Investor Basic Training section of The Loonie Doctor DIY Investing Hub expands on that. Here are a few other articles closely related to this one.
My Net Worth Dropped. My Financial Goals Were Met.
In this post, I review some of my own investing journey and portfolio returns. How I learned and adjusted how I manage my portfolio over the years. Including how I felt during market downturns. I put that into the context of my financial goals and what I can control.
Meshing Your DIY Investments with Other Assets
This is a page I built for those considering how all of their different assets might fit together. Like DIY investments, managed investments, real estate, pensions, permanent life insurance policies, or an active business. There is no perfect answer, but trying to quantify and consider your overall portfolio is important.
Leave a Reply