Seeking Aleph
Alpha (noun) — A measure of investment performance on a risk-adjusted basis
Aleph (noun) — a mathematical expression referring to the infinite
The standard model of wealth management is known as “asset allocation”. While it’s great to have a model and discipline when it comes to investing and managing one’s long-term finances, the asset allocation model ignores some fundamental realities which are hard to model.
By graduating from the asset allocation model to a dynamic process which honors these realities, I believe it is possible to increase one’s velocity of wealth, while hedging against the systemic and “black swan” risks which make a pure asset allocation model vulnerable. My thinking has been shaped by my own experiences, plus reading these seminal works:
What’s Wrong With Asset Allocation?
According to Investopedia, asset allocation
is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
The problem with this model is it denies the following realities
- Asset classes are highly correlated
- True risk is not quantifiable
- Upside and downside are not symmetrical
- Managing liquidity is more important than managing risk
Let’s dive into these in more detail.
There’s no such thing as uncorrelated assets (anymore)
The math behind asset allocation depends on diversification across independent asset classes to mitigate risk, and thus reduce the volatility of the overall portfolio. But the reality is, the world is getting more interdependent, more correlated, over time. Just for example, the prices of stocks and bonds used to be largely uncorrelated, but now they are highly correlated.
This is not to say that diversification isn’t a powerful tool for hedging risk and volatility (it is). But by relying on the false assumption of independence, the asset allocation model actually takes on hidden risks, which can outweigh the benefits gained by diversification.
Unquantifiable “black swans” are the biggest risk to your wealth
What would happen to your perfectly allocated portfolio if your money manager embezzled everything? Or if the U.S. Dollar suddenly collapsed? Or if there was a coup and the new government confiscated all your holdings? While difficult to quantify, these are actually known risks (sometimes called “grey swans”). Now try to imagine the risks you can’t imagine. See the dilemma? These are black swans, the so-called “unknown unknowns”.
As Taleb goes to great pains to explain in The Black Swan, the unknown-unknowns are a lot more prevalent than we ever imagine, and a lot more dangerous. What’s more alarming is how — because of increasing connectivity and interdependence — black swan events are becoming more frequent and more destructive.
The asset allocation model uses quantified risk assessment and quantified risk tolerances over quantified time periods to determine how much to allocate to which asset classes. Since black swans are unquantifiable by definition, the asset allocation model blatantly ignores the biggest risk to your wealth. And what’s even worse, the more you rely on risk models, the more risk you are actually creating for yourself (this is one of the central themes of The Black Swan, and the primary cause of the 2008 financial crisis).
Downside is limited, but upside is unlimited
Unless you are using leverage or derivatives, the most you can lose is your initial investment. But with certain types of investments (like equities) there is no hard limit to the amount of gain you can achieve. Prices can go to zero, but they are unbounded on the upside. Combine this fundamental asymmetry with the existence of positive grey swans — aka “unicorn investments” — and the asset allocation model is increasingly mismatched for a globalized, interdependent economy.
Managing liquidity is more important than managing risk
Because the biggest risks — and biggest opportunities — come from outside your portfolio, liquidity is the key for both hedging your risk on the downside, and generating superior returns on the upside.
The ‘Seeking Aleph’ Process
Static models like asset allocation get run over by living reality in the form of black swans and unicorns. Instead of a “set it and forget it” mentality, I’m going to describe an active process for investing and growing assets which is more in line with reality.
1. Create Barbells
This is what asset allocation looks like:
And this is what a barbell strategy looks like:
The key difference is that the entire asset allocation model fits in the “medium risk” zone of the barbell strategy. The main problem with asset allocation its that the payoff is too small to justify the actual risk your portfolio faces (due in part to mispriced black swan risk). As you can see, the stock market was relatively stable until the birth of the internet (and economic interdependency), at which point volatility went through the roof:
The key to the barbell strategy is how it creates a base of low risk (and low volatility) with most of your assets on the left side, and it takes extreme risk with the smaller portion (right side) in hopes of capturing a unicorn.
To make this concrete, Twitter’s value increased 160x in just four months in 2007. And then while the stock market imploded and America defaulted on its home mortgages, it increased another 264x. All told, first round investors in Twitter who sold on the day of their IPO would have netted over 100,000 times their initial investment. Meaning, you could have turned $10K into $1 Billion if you’d captured that unicorn.
Now, the chances of picking a unicorn startup at the seed stage is about 1 in 1,000, so a diversified right side portfolio effectively might yield 100x instead of 100,000x. A typical barbell ratio might be 90%-10%. So if the 90% is expected to yield little to no returns, and the 10% increases 100x, the blended ROI is (0.9*1)+(0.1*100) = 11 times return on capital. (This is equivalent to 30% compounded returns over 9 years).
By contrast, to get 11x returns with a medium risk strategy like a public index fund, you would need at least 30 years, even if you had invested during the greatest 30-year run in history:
2. Look for Network Effects
In order to capture unicornesque returns you will need to look for investments which are subject to network effects. This almost certainly implies internet technology as a core aspect to the business or investment. Here are some examples which have increased 100x or more in under 2 years’ time:
- Domain Names: e.g. Beer.com ~ 1,000,000 x in 10 years
- Seed Stage Startups: e.g. Facebook (10,000 x in 6 years)
- Cryptocurrencies: e.g. Bitcoin (22,000 x in 2 years)
One caveat when hunting unicorns like the above: they are only obvious in retrospect (at least to those who didn’t invest in them). And by the time they are obvious to many people, the bulk of the upside is gone.
So by definition, hunting for unicorn investments in well-understood asset classes is going to be less fruitful than simply being open and alert to “once in a lifetime” opportunities that you have unique access to (and which you understand enough about to make an informed bet on).
By virtue of keeping most of your portfolio liquid and safe on the left side of the barbell, you can feel confident in taking the risk required on the right side.
3. Manage Liquidity
While it’s impossible to properly quantify risk, we don’t have to quantify it to know that greater diversification means lower risk. And the greater the diversification, the greater the risk reduction. Which makes diversification one of the keys to the left side of the barbell.
The other key to the left side is liquidity. Liquidity is crucial because it creates optionality.
Opportunities in life come along all the time to make unusually high returns (albeit with high uncertainty and risk). Whether you recognize such opportunities and want to capitalize on them is another story, but let’s assume that you do. In order to actually capitalize on an investment opportunity, you need liquid funds to invest; part of the nature of these unusual opportunities is that they are fleeting. If you don’t jump on them, someone else will, which takes away your option to do so.
So, liquidity in the left side of your portfolio means optionality on the right side, which in turn drives high returns.
Stepping back for a moment and thinking outside of your investment portfolio and into your life as a whole, liquidity plays an important role as well. Because just as potential unicorns dart in and out of your life, so do black swans and grey swans. When you are sitting on a $10 Million illiquid portfolio and your house is destroyed in an earthquake at the same time you are diagnosed with cancer, you understand the value of liquidity.
Ideally you would have liquidity on the right side as well, but often there is an inverse correlation between liquidity and returns. For instance, to capture a unicorn startup, you have to invest at the seed stage, from which point it takes 7 t0 10 years to become liquid.
Also, as a human being it’s difficult — when faced with the optionality of a liquid investment — to not take the option to liquidate once you’ve had a huge gain. But often the biggest returns are realized when you are forced to sit on your hands and “let it ride”. Consider the Twitter example above….
Here’s another example: if you’d bought $1,000 worth of Bitcoin in October of 2010 at $0.06 and sold it in February of 2011 for $0.60, you would have made 10 times your money in just four months. But then you would not have participated in the 2,000x run up from Feb 2011 to Nov 2013. Meaning your $1,000 initial investment could have been worth $20 Million instead of $10K if you didn’t succumb to the temptation to sell too early.
Here’s the lesson: illiquidity on the right side can be a positive forcing function, enabling you to apply a proper barbell strategy.
4. Diversify on the Left Side
When seeking to minimize risk on the left side, we must remember that no single asset class is safe from systemic risks, not even cash. So the key is to use diversification on the left-side to hedge as much risk as possible.
Examples might be to split “cash” into various currencies, like Dollars, Euros, Yuan, etc. Also, hold cash in different bank accounts, some electronic, some paper bills. Make sure to diversify holdings across physical locations for paper and coins, and different sovereign jurisdictions for your multiple financial institutions.
Finally, be sure to hold some of your cash portfolio in alternative forms of cash in case all the sovereign currencies crash at once (i.e. global financial meltdown). This includes gold coins, physically held in different secure locations that you have access to. And it also includes a diversified portfolio of cryptocurrencies, including Bitcoin.
Now, you may be mentally cramping at this point because I am suggesting holding some Bitcoin on the left side of your barbell. But what I am actually recommending is a highly diversified portfolio of (hopefully) uncorrelated liquid assets. I am not suggesting that you have more than 10% of your left side in any one instrument.
5. Asset Allocation is for Retirement Accounts
The one place where asset allocation makes sense is in retirement accounts you won’t need to access for the next 15 years. The reason is twofold:
- There are asset classes (like real estate, and early-stage startups) where you can trade liquidity for returns and yield 20% or more annualized — if you can wait up to 15 years for liquidity.
- Retirement accounts are typically tax-deferred, which means you can triple your effective yield by shielding realized gains.
The key is to diversify as much as possible, and avoid management fees if at all possible, as they kill your returns over time.
To Summarize
LEFT SIDE: 90% of your portfolio, highly diversified liquid assets
RIGHT SIDE: 10% of your portfolio, high risk/reward, possibly illiquid, but not overly-diversified
RETIREMENT ACCOUNTS: It’s okay to use asset allocation, just avoid management fees and diversify as much as possible.
