- Pick Your Own Investment Return
- My Mentor on Risk
- Barbell Investment Strategy
- Future Predictions
- Manage Your Risk
- Truly Safe Investments
- Hidden Risks of the Dangerous Middle
- Chance of Wipeout
- Risk Splitting
- Stop Playing When You Won
- High Returns are Enticing
- Mostly Stocks
- Three Floors of Risk
- So, what’s a modern investor to do? Well, I’m not sure what you should do. But I will tell you what I do. I think in terms of three layers of investing. Let’s build a three-story house.
- First Floor – The Secure Base
- Second Floor – Market Return
- Third Floor – High Investment Returns
Return on investment indicates how much your money will earn for you. Return of investment should be our primary concern followed only by return on investment. There isn’t a return on capital if there is no return of capital.
Pick Your Own Investment Return
Return on investment can be classified as high, medium, or low. We all want a high return on investment. You can pick your own level of return.
But the flip side is you are picking your risk level also. We need to understand that the only way to boost returns is to take on more risk. Risk and return are inextricably linked.
How should we invest our money?
My Mentor on Risk
NN Taleb gave me some personal investment advice. He recommended I “stop trading.” He contends that there is more risk in the financial market than the average investor realizes.
He felt I had enough money to provide a comfortable life. If I continue to put my money at risk in stocks then I could lose enough to reduce my quality of life.
I might be forced to work more than I want. Since this brilliant mathematical philosopher’s net worth is north of the stratosphere, I took his advice to heart. I stopped putting most of my money at risk.
Barbell Investment Strategy
I first learned of the barbell strategy from N.N. Taleb. Taleb is a brilliant thinker, author, and investor. He has a background in philosophy, mathematics (Ph.D.), business (MBA), and derivatives trading. In his best-selling books ( The Black Swan, Antifragile, and Fooled by Randomness), he dishes out practical advice on thinking, life, and investing.
Future Predictions
Here is how he lays out the issue of risk in investing: “If you know that you are vulnerable to prediction errors, and […] accept that most “risk measures” are flawed, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative.”
When I think of a barbell I think of a metal rod with two equal weights. It is symmetric.
That is not what we are talking about here. Maybe it should be called bimodal. Nevertheless, the barbell name has stuck.
Practically this may mean keeping 85% to 90% of your investable funds in short-term Treasury securities or cash and 10% to 15% in speculative, high-risk investing like hedge funds, VC projects, start-ups, options on gold, or angel investing.
Manage Your Risk
Tim Ferriss invests this way by having a portion of his money in high-tech Silicon Valley start-ups. The rest is conservatively invested.
Michael Murphy of the New World Investors also recommends the barbell approach. Unlike Taleb, he considers undervalued, high-dividend-yielding blue chips to be safe. NN Taleb disagrees, pointing to unknowable market risk in stocks that are traded.
Truly Safe Investments
The barbell way of thinking can be applied to bonds. You could invest almost all your fixed-income assets in short-term instruments like U.S. T-bills. Then invest the remaining 10% or so into “junk-bonds” or long-duration corporate bonds.
Hidden Risks of the Dangerous Middle
The key is having no investments in the “middle.” That would be the market where many of you are now invested. You think it is relatively safe, but the smart and experienced do not agree with you.
NN Taleb looks at risk as upside and downside. If you have most assets in the “safe” bucket, then a crash will not harm you. If you have some assets in the “speculative” bucket, then you have unlimited upside potential.
Chance of Wipeout
As an example, let’s say you have two investment options: one is high-risk and likely to pay a 33% return. Don’t laugh, those investments are out there. A lower risk option returns 5%.
How would you allocate your funds? Since 33% is an outstanding return, you could put the bulk of your money there – but there is a significant chance that you could get nearly completely wiped out.
Risk Splitting
If you chose only the 5% option, you would not grow your wealth. If you put 85% in the low-risk and 15% in the high-risk option, there is almost no chance of a total or even significant loss.
And yet your return would be quite healthy: 85% of 5% + 15% of 33% = 9.2% return. Not bad for a portfolio that is 85% safe!
Stop Playing When You Won
The barbell portfolio works very well. It allows some growth but avoids catastrophic loss. Another wealthy genius who has given me advice is Dr. Bill Bernstein.
He too counsels that once you made “enough,” stop putting money at risk. Why stretch for a higher return that won’t benefit you. It only puts your needs and lifestyle at risk. This is brilliant advice.
High Returns are Enticing
But still, the siren song of the financial markets call to me. I have made an enormous amount of money investing in individual stocks, mutual funds, and ETFs.
I acknowledge that there are inherent risks that I don’t understand. But, I also don’t like it when I’m not benefiting from the overall growth of the American businesses.
I can’t seem to block out all the financial news. I want a piece of the action. Also, I am not as connected or as bright as Drs. Taleb or Bernstein. My high-risk part of the dumbbell isn’t likely to pay off the way theirs might. Sometimes I feel like I’m the dumbbell in this portfolio method!
Mostly Stocks
Most investment advisors recommend we invest heavily in stocks. The long-term stock market performance record is indeed excellent. Assuming we don’t panic and sell at the wrong time. By saving regularly and investing in stocks, building wealth can be simple.
Bonds can help produce income and reduce volatility. Unfortunately, current bond returns are low and unsatisfying.
Three Floors of Risk
So, what’s a modern investor to do? Well, I’m not sure what you should do. But I will tell you what I do. I think in terms of three layers of investing. Let’s build a three-story house.
First Floor – The Secure Base
The first floor is the low-return floor. It is the secure base. It won’t grow much, but it won’t crash by 40% either.
This reduces the volatility of your overall portfolio. It also could provide funds in a bear market.
That way you won’t have to sell a lot of shares at a loss to provide liquidity. This category can include money market funds, T-bills, CDs, high-grade short-term corporate and government bonds, TIPS, GNMA funds, and good old-fashioned cash.
The goal here is safety, not large return and growth. Maintain and maybe go up a few percents per year. For me, this is 40% of my total investable assets.
If the two top floors crash down or are in temporary disrepair I could live on this main floor for many years.
Second Floor – Market Return
The second floor is the medium return floor. It is the market. This may return 8-10% on long-term averages but could be up 35% or down 70% in any given year.
The engine of the US economy is captured here as are multinational companies. This could be large dividend-producing stocks, S&P 500 index fund/ETF, foreign equities, etc. This medium risk (in the long term) floor accounts for 40% of my funds.
Third Floor – High Investment Returns
The top floor is the third floor and it is high return. This is a lot riskier than the market. In fact, one must be an insider, entrepreneur, business owner, and/or accredited investor to even have access to many of these.
This could include hospital ownership, your own company, small business angel investing, leveraged real estate, surgery centers, senior living facility investments, buying stock on margin, derivatives, etc.
These tend to be speculative. The risk of loss is real. On the other hand, returns of 25%-40% are routine. Currently, this accounts for 20% of my investments. I usually call it “other.”
I currently invest in a 40/40/20 model with bonds/stocks/other representing those categories. It has worked well for me.
Stability is always present on the first floor.
Growth comes from the second and third floor.
So far, my house is accommodating and solid enough in its construction to withstand a financial shock. How about yours? Do you risk-stratify your investment return?
For more insight into this risk-stratification model, check out the Aspirational Investor.
Another one of many ideas of how to allocate your money for the best outcome. Everybody wants safety and great returns but you can’t have both. This looks like a good plan for a stable compromise. With each new article like this, I’m actually warming up to the idea of buying bonds as I age. My portfolio still has several decades to grow.
Dr. Cory S. Fawcett
Prescription for Financial Success
Dr. Cory S. Fawcett recently posted…Success is Not Measured by Income
Dr. Fawcett,
From what I know about your financial situation, you should be fine no matter what. There are tremendous risks in stock investing but most of those are short-term. If you have the resources (e.g. real estate rental income, savings, income margin of safety) and the mental fortitude to weather the storm, you can have minimal to no investment in bonds and be fine. I like to see my net worth go up each year. I might be richer at some point 20 years from now if I invested only in stocks. But I want it to go up most years or every year, not crash and then recover over a decade or two. That is really a personal choice.
I too feel that I am not connected enough or in the know to make wise speculative deals. That high risk high reward of the dumbell maybe just the weight that falls off and lands on my foot.
It is a great concept and if indeed you were wise enough to model a portfolio following that it seems to produce a decent return.
My strategy is trying to get income generating assets that would provide me with a stable income floor that would allow me to not lock in losses by selling depressed assets. It is akin to your first floor in the model
Xrayvsn recently posted…The Doctor’s Bill: Late Bloomer Physician Retirement Home/Nest Egg
It sounds like you have a solid plan, Xrayvsn.
Nothing beats income producing assets when it comes to calming nerves during market turmoil.
When investing good money, I often see both security and ROI. Just focusing on one of those does not make sense especially if you are investing tens of hundreds of dollars. Same goes for financial experiments like crypto and other new investments. Equity funds is the only instrument that I allocate most of my savings to because I’m on a long-term goaling…
Tim,
Seeing security and return together is wise. They are like a teeter-totter. Both seats are connected to each other.
You mentioned crypto and other “new investments.” That raises a point. There is a difference between speculation and investment. I agree with Ben Graham on this one. Most physicians should stick to investing, not speculating.
Exactly. Also, I do not have huge dreams that will require me to go the extra, extra mile. I’m satisfied with my current portfolio and it looks good for me and my next generation at least.
Tim,
I agree. I’m satisfied with a reasonable return and modest growth. Most doctors don’t need to invest aggressively or speculate. We make enough money that we can save a lot, make a ton of mistakes, get reduced returns and still come out fine.
If you are satisfied with your portfolio for 1-2 generations then you have done a lot of things right! Congratulations!
How do you quantify your return and risk? Every portfolio boils down precisely to a single return and its inherent single risk and there is NO reason not to quantify this. It is entirely do-able. To not quantify this is simply to delude yourself with visions of hitting it out of the park. The real metric to focus on is probability of success. Your scheme basically has a built in sequence of return risk beyond normal SORR and it exists whether the portfolio is open or closed from that 20% marker. From my perspective you are still gambling. You have 60% of your money bet on black. Let’s say it’s red. In the worst case 20% evaporates and half of the other 40% equity exposure evaporates, so you loose your 20% and half of your remaining 40% equity exposure. You’re out 40% and that means you have only 60% left. That means you need to make 120% just to get back to even. If it took you 10 years to get to 60% it’s going to take >10 years years of full steam ahead investing (read that work) to get back to where you started from when the crash happened. If you didn’t have a fully funded portfolio when the crash happened you are taking an additional number of years to get to fully funded. No early retirement for you! Risk management involves not only playing with ratios but considering the time it takes for those ratios to manifest. Compounding strictly manifests in the time domain. In the 2008 crash a 50/50 portfolio was even in 2 years. A 100% SPY portfolio took 5 years to get back even. By 5 years the 50/50 portfolio had 3 additional years of compounding. Good article.
Gasem,
You always have thought-provoking comments!
I agree that quantifying return is clear and easy to do. Quantifying risk is a bit more complex. Typically in the finance and MBA community variation and volatility are the mainstays of risk measures. They may make assumptions about standard deviations and normative data. They also don’t consider that upside gain isn’t really “risk” the way a downside loss should be. I was one of two MBA students in my finance class who questioned these measures. We were literally laughed out of class. That was 2006. 2008 showed some of the problems we talked about. Others like NN Taleb explained why the existing risk measures were faulty. One reason is they don’t account for the rare “off-model” catastrophic losses that pop up occasionally in real life. They get assumed away, glossed over, or ignored in the theoretical presentations.
So I’m not sure if the how to quantify risk question was real or rhetorical but my answer would be too long for a comment section.
I’m not sure that I agree “my scheme” has an increased SORR? It actually has less risk in my view since losses are minimized with barbell investing (if that is the “scheme” you are referring to?)
No early retirement for you? For who? NNT, Bernstein, or I could retire at any point. The system of investing works just fine. It is actually a conservative method of avoiding losses. You mention the arithmetic that if you have a 50% loss you will need a 100% gain to get back. That is true and important to know. NNT who has a PhD in math is also aware of that. That is part of why he suggests keeping most of your portfolio in safe assets.
So your last point is interesting too. After 2008 a balanced portfolio didn’t go down as much as a total stock fund. So it got back “to even” three years sooner. Okay, that may be true. But who would come out ahead over the last decade? The total stock fund would be much higher now, right?
I participate in a bit of it all. I am NOT married to any particular investment.
I see the value of “know nothing, do nothing” with index investing. I also see the benefits of having positive cash flow RE.
I see the benefits of having real assets such as agricultural land and precious metals.
I see the benefits of using government benefits if all my other investments go to the crapper.
There are a myriad of ways to get where one needs to go.
I barbell my life so I understand exactly what Taleb talks about.
I’m glad you liked the post.
Commodities and metals tend to invite speculators as well as investors. That increases their volatility.
You may want to consider investing in timber too. It is an interesting asset class that produces a slow but consistent income at moderate risk.
Actually the 2 portfolios, bar bell and balanced tend toward a mean for the particular local period of retirement. Here is a real time example lets say you retired invested in 100% SPY in Dec 1999. Till 2018 100% SPY the actual annualized yearly return on 4.6%/yr dividends reinvested. The period covered 2 recessions and about 2/3 of a normal 30 year retirement. If you pulled out 4% per year you grew at 0.6%. If you had a 50/50, VBMFX averaged 5.75% over the same 18 yr period 18 yr period period so the average would be (5.75 + 4.6)/2 or 5.1%. If you pulled out 4% your money grew at 1.1% So while the long term expected return of the SPY is 10% in fact it dramatically under-performed in this 18 year retirement period due to it’s volatility, where as bonds were in a 30 year bull market and over performed. SORR matters.
If you Monte Carlo a 4% WR 100% SPY portfolio for 30 years it fails( as in runs out of money) 11% of the time by 30 years. If you Monte Carlo a 50 50 SPY/VBMFX same 4% same 30 years it fails only 2.8% of the time. The 50/50 represents the bottom and middle of your portfolio and no top. Add AMZN in a 20 amzn 30 spy 50 vbmfx mix and you get 99% success this is the barbel that does well. Add GE and take away AMZN and the 20/30/50 fails 11% of the time same 4% WR 30 yr withdrawal. The failure rate is a DIRECT measure of excess risk.
The way to play this is to own 2 separate portfolios, one investment and one speculation and do not co-mingle the analysis. Fund the Investment portfolio to a level that gives you 97% success in funding your life and fund the other however you like. If speculative wins take out some money at least as much as you started with and put it in investment. This is called a free trade and turns your speculation into free money. Leave the rest of the free money in speculation. If speculation fails you have the 50/50 to adequately fund your life to a 97% level of success. I’ve done this many times in my life. I had an investment portfolio and a spec portfolio. Every time the spec portfolio hit, I extracted the seed money and let the free money ride till I decided to sell it. I did this with BTC. I bought BTC in 2015 with free money that had grown 600% after extracting the seed money from a penny stock deal I was speculating on. I sold out at 600% and put half in my invest portfolio and half in BTC. That BTC speculation went up 6900% On the way up I sold the seed money and put it in BRK.B in the invest portfolio and let the free money in BTC ride. BTC is still up 1300% and that money is all free money because the seed is in BRK.B. The seed came from the free money I had in the penny stock. IfBTC goes to zero (which it won’t) I’m out nothing. At no time was my WR money at risk and all the time my speculation money paid my investment portfolio not vis versa. I’m very aware how you do this, and it’s all about rules based risk management.
Gasem,
I agree that there are ways to use profits from investments and speculate with a portion. That can compound returns without adding much risk.
I have done some trading arbitrage and private company investments that have turned out well. Much of my success may have been driven by luck though – looking back.
Also, many of my readers don’t have the knowledge, time, or inclination to do advanced trading strategies.
Those strategies may work, but they aren’t easy. And they aren’t necessary for physicians to get a decent return at lower risk levels.
Curious if you can elaborate about what your other is made of? Real estate? Timber?
Enjoy your posts WD as they always teach me something. I first got hold of printed advance chapters of black Swan from an economist friend in Ethiopia in 2005, and devoured it. Still, I’m probably not derisking my life as well as I should in consideration of the premise of the book. Don’t think I’m knowledgeable enough to pick the long shots that would comprise the high risk end of the barbell.
Thanks for the thought provoking post,
CD
Crispy Doc recently posted…How My Donor Advised Fund Made Me Less Selfish
CD,
… an economist friend in Ethiopia… man you have some interesting stories!
NNT is a genius. He doesn’t suffer fools gladly though. Fortunately, he tolerated me well enough to give me some advice. I cut back on my more speculative investments for the bulk of my portfolio – largely based on his advice. I think it helped me survive the GFC of 2007/2008.
I’m with you about the lack of time, opportunity, luck, and knowledge to have a lot of 100X investment opportunities. Tim Ferriss was connected in Silicon Valley and was able to invest in many tech start-ups. NNT understood hedging and options tradings and eliminated the downside while maintaining the upside. I had some good investment ideas but Taleb reviewed them and thought as an “outside” investor the transaction fees would eat me alive. Only a true “market maker” could carry out some of what he and Mark were doing with derivatives.
So back to your question: My “other” category is variable. Nothing too extraordinary. Currently, it is mostly real estate and private companies. Through LLCs and such I have interests in commercial real estate (MOB – medical office building), a startup tech private company, an early stage manufacturing/IP private company, apartment buildings, a real estate fund, single-family rental houses, two surgery centers, and an imaging center. I guess you could include my blog and online work but it isn’t worth much currently.
This is all very confusing to me. I currently have a portfolio of around $900,000. Plus I own my home outright, approximately $350,000. I have no debt. I am 68 years old and my portfolio is modeled on me living to 93.
I want to spend about $150,000 on a vacation home. But I was told if I do so, I would only be “45% Fully Funded” if I live to be 93.
Does this mean at age 93 I would have NO assets left, or does it mean I would have 45% of the $900,000 (plus or minus based on inflation, etc). I currently have $1,200 a month deposited to my checking account and occasionally need a bit more for unexpected expenses.
I want to leave money to my children and they will have the house. But does that have to mean I can’t splurge on a vacation home? I am a single parent, worked hard my whole life, and both my children graduated college with no debt. They both went on to earn MBAs (I didn’t pay for that) and one completed his CFA.
Any information you could provide would be greatly appreciated!
Alyce,
Thank you for the comment.
As the post describes a lot of this comes down to your tolerance for risk. It also depends on how you are currently invested, your actual annual expenses, and other sources of income (such as Social Security), etc.
You should be very proud to have accomplished so much. For a single parent to have put their kids through college without debt and still end up with a free-and-clear house and nearly $1M is very impressive. Much better than the average two-earning household in America.
The specific question you ask relates to a particular portfolio modeling that someone must have done for you. I can’t give specific investment advice on this site. Nor am I a certified professional money manager. I ordinarily recommend a fee-only financial planner. You may have one. You can contact me if you want further personal information or recommendation/referral.
If I had two MBA (and a CFA) in the family I would likely rely on them rather than a professional who may not have your best interest as their top priority.
Lastly, I will share that my mother doesn’t really have enough money for her own luxurious retirement. She is focused on leaving me money or a house. I have no interest in either. I have done well and would rather she spend her money and enjoy her remaining life. Your children may feel the same. That is an important discussion to have.
I like the blog! Is there anywhere you discuss the dividend stocks in which you’ve been interested / invested?
Glad you like the blog.
I love dividends (unlike a lot of physician finance bloggers like PoF).
I have written a lot about it, but unfortunately, they are all on my old defunct dot-com website.
I will transport them and update them at some point. So stay tuned.
Have you invested for dividends? Any funds or stocks you are considering?
Hiya – nope, I don’t have any yet but like the idea as maybe a quarter or third of my stock portfolio. Hope to see some of your favorites soon!