In 2004, author Barry Schwartz published his book The Paradox of Choice – Why More Is Less. Schwartz argues that too many options can lead to anxiety and decision fatigue for customers.
We live in a world where choices and options abound. As a consumer, I am thankful for places like In-N-Out Burger, which makes my decision-making process easy – I am getting a burger and fries.
Investors face an investing landscape that has evolved from the world of stocks, bonds, and cash to an ecosystem where you can now invest in anything and everything. Do you want to own a micro position in farmland? You can. How about taking a minority position in a classic car? There is a platform for that. Art? Wine? A claim on a prospective professional athlete’s future income? Sure.
As I said, you can now invest in ANYTHING? But the question is, should you?
Interest rates are low. Lower than they’ve ever been.
This means that traditional strategies and approaches to portfolio construction have been disrupted. The old playbook feels like it just doesn’t apply.
When presented with the choices of stocks, traditional bonds, and cash, today’s investor tends to lean toward more stocks.
BUT the godfather of modern portfolio theory and Nobel Prize winner, Harry Markowitz, famously said, “Diversification is the only free lunch.” Now 94 years young, Markowitz would cringe if we were to pile into more stocks just because cash and bonds have lost their oomph.
So, what are we to do?
Before we get to the solution, let me present the “buyers beware” speech.
The powers that be in the world of financial marketing are always two steps ahead of you. If a concern – minor or major – pops into your head, they’ve [Mr. Marketing] already got three products to present to you as a potential solution. The I-think-inflation-might-be-a-concern-I-should-consider fund or the hmmm-should-I-have-some-exposure-to-cryptocurrencies? fund.
You should have – scratch that – you must have your guard up. This is your money, your hard-earned money. An old boss always used to tell me, “Know what you want for yourself because someone else already knows what they want for you.”
Now, back to the solution. Remember, the problem is (1) lower interest rates limiting your ability to generate a meaningful return and (2) the need to diversify beyond just stocks.
Welcome to the world of alternatives. Alternatives, this “catch-all” category where we place any investment that is not a stock, bond, or cash. Knowing that the category is so broad should sound the alarm for the need for significant diligence.
The Paradox of Choice
As I mentioned earlier, investors are presented with the option to invest in a wide array of alternatives. You need a process for determining what exactly you should consider investing in.
I will provide you with my simplified two-question analysis that will help when vetting out alternatives, but first, some Family Guy.
A little context, Family Guy, an animated sitcom that started in the late ’90s, created by Seth McFarlane – sometimes a bit crude, but often poking fun at pop culture and the familiar quirks of life. Let me set the scene for you. Peter and his wife Lois just sat through a long and grueling timeshare presentation, all because they were offered a free boat – yes, a free boat – for attending. Right before the presentation wraps up, the slick salesman makes a proposition to the couple – they could (1) take the free boat, or they could (2) take the mystery box. Unwilling to listen to Lois’ wise counsel, Peter blurts out:
“A boat’s a boat. But the mystery box could be anything. It could even be a boat! You know how much we’ve wanted one of those. We’ll take the box!”
The box was two tickets to a subpar comedy show. To me, this scene is both hilarious and familiar. The mystery box, the shiny object, the “new” investment strategy can lure us into making bad decisions.
When vetting out a potential alternative, there are two questions I think all investors should ask: Why? How?
Why should I own this strategy? And How will I go about allocating to this strategy?
Remember, an investment portfolio is meant to fulfill the objectives of a financial plan. This means that the individual parts of a portfolio also need to collectively fulfill the objectives of a financial plan. Your financial plan should outline all of your liquidity needs, return targets, and tolerance for volatility. When adding an alternative to a portfolio, you are either (1) replacing something else or (2) opting not to own something else. You must answer the question “Why?”
Once you’ve concluded that this allocation has a role and purpose in your portfolio, you then have to figure out how you’re going to go about gaining that exposure. The type of security – ETF, Mutual Fund, Hedge Fund, etc.? The manager? The institution? This diligence process cannot be short-changed.
If you’re a regular reader of the Dividend Café, think about how much David Bahnsen has recently put out regarding his thoughts on Chinese sovereign debt. David is peeling back the curtain and letting you look into the “why” diligence. His thoughts, his conversations with other professionals, his assessment of the risk/reward, etc. The process does not stop here, though. David might be 90% down the field or intellectually convinced that this allocation is appropriate for our clients, then starts step two – what is the best way to go about getting this exposure? Some diligence projects will result in step one passing the test but not finding a viable “how?”
I have endless examples of investments that were great in theory and failed in execution. Here at The Bahnsen Group, our team looks for strategies with long track records and stable capital bases backed by strong businesses. Again, we’ve seen the horror stories, and we know the importance of thorough diligence and a rigorous process.
I often find myself telling people that if it sounds too good to be true, it is probably… too good to be true. In the world of investing, returns aren’t free; they come at a cost, a cost we often refer to as risk. Risk can take many forms – from illiquidity to volatility and everything in between. It’s important not to be blind to risk; in investing, ignorance isn’t bliss.
In The Bahnsen Group brochure, David Bahnsen answers the question “Why Alternatives?”
“The only “free lunch” in investing is diversification, and at the core of diversification is allocating capital to different sources of risk and return. Alternative investments are simply those that de-correlate from traditional asset classes like stocks and bonds, something much easier to talk about than do. We do not use alternatives to enhance return, and we do not even necessarily believe they “lower risk.” We believe they “change risk,” and that is an entirely, well, alternative concept.”
I will highlight one key descriptor from the quote above, alternatives “change risk.” This is such a key concept for investors to understand. You will not eliminate risk, but there are great benefits from diversifying your sources of returns. Some investments are sensitive to oil prices; others might move and shake with interest rates or zig and zag with inflation – the goal is to have a robust source of returns that are not all correlated to the same sensitivities.
I’ll wrap up today with this reminder; diversification doesn’t always feel good, and it’s a lot like exercise – difficult but necessary.