WEBVTT 00:00:00.000 --> 00:00:02.120 Welcome back to the Deep Dive. This is where 00:00:02.120 --> 00:00:04.839 we take a pile of, well, frankly, dense sources 00:00:04.839 --> 00:00:07.299 and we try to strip out all the jargon to hand 00:00:07.299 --> 00:00:09.720 you the core ideas, the intellectual blueprint. 00:00:10.000 --> 00:00:12.720 And today we are going deep. We're getting into 00:00:12.720 --> 00:00:15.480 the engine room of investing. We are. We're talking 00:00:15.480 --> 00:00:17.500 about asset allocation. You'll hear it called 00:00:17.500 --> 00:00:21.570 AA. And this is not about which stock to pick. 00:00:21.769 --> 00:00:24.250 It's not about the hot tip of the week. No, not 00:00:24.250 --> 00:00:27.149 at all. This is about the core structural integrity 00:00:27.149 --> 00:00:29.969 of your entire financial life. That's a good 00:00:29.969 --> 00:00:32.049 way to put it. We're stepping back from all the 00:00:32.049 --> 00:00:36.009 noise, right? The day to day decisions, the individual 00:00:36.009 --> 00:00:38.560 security selections. Exactly. And we're going 00:00:38.560 --> 00:00:40.600 to focus really intensely on the big picture, 00:00:40.700 --> 00:00:42.840 the macro structure. We're talking about the 00:00:42.840 --> 00:00:45.219 characteristics, the risk profile, and frankly, 00:00:45.320 --> 00:00:47.280 the discipline required for your overall portfolio. 00:00:47.460 --> 00:00:49.539 Right. So our mission today is kind of fourfold. 00:00:49.600 --> 00:00:51.500 First, we need to actually define what this blueprint 00:00:51.500 --> 00:00:54.179 is. Then we have to understand the building blocks, 00:00:54.340 --> 00:00:56.679 you know, what's actually available to you. After 00:00:56.679 --> 00:00:59.179 that, we'll explore the four major strategies 00:00:59.179 --> 00:01:02.460 for how you deploy those blocks. And then, and 00:01:02.460 --> 00:01:07.719 this is probably the most critical part, misunderstood 00:01:07.719 --> 00:01:12.579 academic debates in all of finance. Yes, the 00:01:12.579 --> 00:01:16.079 infamous, and I have to say, often misused 93 00:01:16.079 --> 00:01:19.939 .6 % claim. We'll get there. But first, let's 00:01:19.939 --> 00:01:22.079 start at the beginning. What is asset allocation? 00:01:23.000 --> 00:01:26.090 At its heart, it's a philosophy. It's an investment 00:01:26.090 --> 00:01:29.909 strategy that tries to balance risk versus reward. 00:01:30.170 --> 00:01:32.269 Okay, how? By adjusting the percentage of each 00:01:32.269 --> 00:01:34.930 asset class in a portfolio. And it does that 00:01:34.930 --> 00:01:36.870 according to three main things. Which are? The 00:01:36.870 --> 00:01:39.329 investor's specific risk tolerance, their defined 00:01:39.329 --> 00:01:42.409 financial goals, and the time frame. Yeah. When 00:01:42.409 --> 00:01:44.069 they'll actually need the capital. So it's the 00:01:44.069 --> 00:01:46.150 framework. It's what dictates the whole journey. 00:01:46.329 --> 00:01:48.370 It is. And this entire framework is built on 00:01:48.370 --> 00:01:50.609 something that's often called the single greatest 00:01:50.609 --> 00:01:52.969 advantage available to a regular investor. Which 00:01:52.969 --> 00:01:55.230 is? Well, it's the foundational justification 00:01:55.230 --> 00:01:58.030 for AA. And it comes straight out of modern portfolio 00:01:58.030 --> 00:02:01.269 theory or MPT. Right. And the core idea is actually 00:02:01.269 --> 00:02:04.329 pretty simple. Different assets perform differently 00:02:04.329 --> 00:02:06.849 under different conditions. So stocks do well 00:02:06.849 --> 00:02:09.530 in a boom, bonds might do better in a bust, that 00:02:09.530 --> 00:02:11.650 sort of thing. That's the essence of it. And 00:02:11.650 --> 00:02:14.330 this non -uniform behavior, that's what leads 00:02:14.330 --> 00:02:16.949 us to the concept of diversification. The free 00:02:16.949 --> 00:02:20.370 lunch. The free lunch, exactly. Nobel laureate 00:02:20.370 --> 00:02:23.030 Harry Markowitz famously called it the only free 00:02:23.030 --> 00:02:25.210 lunch you will find in the investment game. A 00:02:25.210 --> 00:02:28.680 free lunch in finance is... Well, it's almost 00:02:28.680 --> 00:02:31.659 unheard of. So why is diversification given that 00:02:31.659 --> 00:02:33.900 title? What makes it free? It's because of a 00:02:33.900 --> 00:02:36.000 statistical property called correlation. Okay. 00:02:36.080 --> 00:02:38.860 Different asset classes, they have returns that 00:02:38.860 --> 00:02:41.560 are not perfectly correlated. Meaning they don't 00:02:41.560 --> 00:02:44.060 move in perfect lockstep with each other. Exactly. 00:02:44.060 --> 00:02:46.500 So if your stock portfolio is taking a huge hit 00:02:46.500 --> 00:02:49.439 because there's a recession. Well, your bond 00:02:49.439 --> 00:02:51.979 portfolio might be holding steady or it could 00:02:51.979 --> 00:02:53.979 even be going up in value because interest rates 00:02:53.979 --> 00:02:56.379 are falling. I see. So the goal isn't to have 00:02:56.379 --> 00:02:58.159 everything go up at once. That's impossible. 00:02:58.439 --> 00:03:01.000 No, the goal is to combine them in a way that 00:03:01.000 --> 00:03:03.500 lets you reduce the overall risk. And by risk, 00:03:03.520 --> 00:03:07.340 we mean the variability of your returns for a 00:03:07.340 --> 00:03:09.580 given level of expected return. So you get a 00:03:09.580 --> 00:03:12.139 smoother ride over time. A much smoother ride, 00:03:12.319 --> 00:03:14.680 without having to sacrifice your expected long 00:03:14.680 --> 00:03:16.719 -term outcome. That makes perfect mathematical 00:03:16.719 --> 00:03:19.759 sense. You use assets that zig when others zag 00:03:19.759 --> 00:03:22.259 to sort of soften the blows. That's the theory. 00:03:22.479 --> 00:03:25.469 But, and this is a big but. I need to pause right 00:03:25.469 --> 00:03:28.669 here because the sources we looked at, they immediately 00:03:28.669 --> 00:03:32.189 threw up a huge red flag, a massive caveat in 00:03:32.189 --> 00:03:35.150 this whole theoretical structure. Yes. We have 00:03:35.150 --> 00:03:37.870 to introduce what we could call the major weak 00:03:37.870 --> 00:03:41.370 link in traditional AA. The weak link. What is 00:03:41.370 --> 00:03:44.069 it? While the theory of MPT and diversification 00:03:44.069 --> 00:03:46.889 is powerful, the way we actually implement it 00:03:46.889 --> 00:03:49.909 relies very heavily on looking backward. Looking 00:03:49.909 --> 00:03:52.370 in the rearview mirror to drive forward. A perfect 00:03:52.370 --> 00:03:55.030 analogy. We rely on statistical relationships, 00:03:55.370 --> 00:03:56.990 things like correlation, variance, historical 00:03:56.990 --> 00:03:59.930 returns that existed over some period in the 00:03:59.930 --> 00:04:02.569 past. To try and forecast the future. And that's 00:04:02.569 --> 00:04:04.090 the challenge, isn't it? You're feeding historical 00:04:04.090 --> 00:04:06.949 data into this machine that's supposed to map 00:04:06.949 --> 00:04:09.250 out a future that might behave in a completely 00:04:09.250 --> 00:04:12.030 different way. So what happens when those historical 00:04:12.030 --> 00:04:15.509 relationships, you know, break down in a crisis, 00:04:15.569 --> 00:04:18.399 for instance? That is precisely when the weakness 00:04:18.399 --> 00:04:21.040 gets exposed. There's this traditional technique 00:04:21.040 --> 00:04:23.240 for optimizing a portfolio. It's known as the 00:04:23.240 --> 00:04:26.420 mean variance optimization approach. That's complicated. 00:04:26.860 --> 00:04:28.939 It is. But the key thing to know is that it's 00:04:28.939 --> 00:04:31.300 extremely sensitive. It's the math that tries 00:04:31.300 --> 00:04:35.079 to map past volatility onto future risk. But, 00:04:35.199 --> 00:04:38.680 and here's the kicker, if you get those initial 00:04:38.680 --> 00:04:42.259 inputs even slightly wrong, The historical volatility, 00:04:42.519 --> 00:04:45.660 the correlation estimates? Yes. If those are 00:04:45.660 --> 00:04:47.899 off by just a little, the recommended allocations 00:04:47.899 --> 00:04:51.459 can become, as the sources put it, grossly skewed. 00:04:51.660 --> 00:04:53.819 Grossly skewed. Give me an example of what that 00:04:53.819 --> 00:04:55.699 looks like in the real world. Sure. Let's say 00:04:55.699 --> 00:04:58.699 the optimization model mistakenly forecasts that 00:04:58.699 --> 00:05:01.560 some exotic asset class will have a slightly 00:05:01.560 --> 00:05:03.680 lower correlation with global stocks than it 00:05:03.680 --> 00:05:06.120 really does. Okay. The model might spit out a 00:05:06.120 --> 00:05:08.540 recommendation to put 60 % of your entire portfolio 00:05:08.540 --> 00:05:11.399 into that one single asset. Which is just, it's 00:05:11.399 --> 00:05:13.379 common sense that you wouldn't do that. Of course 00:05:13.379 --> 00:05:16.160 not. It violates every rule of practical portfolio 00:05:16.160 --> 00:05:19.339 construction. It's the classic garbage in, garbage 00:05:19.339 --> 00:05:22.360 out problem, but applied to market history. And 00:05:22.360 --> 00:05:25.480 it just confirms that AA is less about finding 00:05:25.480 --> 00:05:28.800 a single magic formula and much more about applying 00:05:28.800 --> 00:05:31.800 a prudent, sensible structure. Okay, so if the 00:05:31.800 --> 00:05:34.060 structure is everything, we really need to understand 00:05:34.060 --> 00:05:36.620 the raw components we have to build with. Let's 00:05:36.620 --> 00:05:38.920 try to streamline the menu of options and focus 00:05:38.920 --> 00:05:42.399 on the... The behavioral role of these assets. 00:05:42.740 --> 00:05:45.379 Good idea. Let's start with the traditional trio. 00:05:45.560 --> 00:05:48.100 The three pillars. Stocks, bonds, and cash. And 00:05:48.100 --> 00:05:49.879 when you're building this AA blueprint, you're 00:05:49.879 --> 00:05:51.620 not supposed to be thinking about, say, Apple 00:05:51.620 --> 00:05:53.759 versus Microsoft. You should be thinking about 00:05:53.759 --> 00:05:56.339 the risk function each asset class performs in 00:05:56.339 --> 00:05:58.959 the portfolio. Got it. Let's start with stocks 00:05:58.959 --> 00:06:01.680 or equities. What is their fundamental role in 00:06:01.680 --> 00:06:03.759 this structure? They are the growth engine. That's 00:06:03.759 --> 00:06:06.209 it. They're the primary source of your long -term 00:06:06.209 --> 00:06:08.689 returns. And just as importantly, they are the 00:06:08.689 --> 00:06:11.350 major contributor of your portfolio's volatility. 00:06:11.649 --> 00:06:13.970 The bumps in the road. All the bumps in the road. 00:06:14.230 --> 00:06:16.930 And within equities, the really key behavioral 00:06:16.930 --> 00:06:19.310 distinction isn't so much micro cap versus large 00:06:19.310 --> 00:06:21.790 cap. It's more about the underlying style. You 00:06:21.790 --> 00:06:24.850 have growth strategies, which are all about pursuing 00:06:24.850 --> 00:06:27.709 companies focused on rapid expansion. Think high 00:06:27.709 --> 00:06:29.589 -flying tech. And then the other side of the 00:06:29.589 --> 00:06:33.410 coin. Is value strategies. These focus on companies 00:06:33.410 --> 00:06:36.870 that are trading cheaply relative to their intrinsic 00:06:36.870 --> 00:06:39.730 worth. More established, maybe less glamorous 00:06:39.730 --> 00:06:42.089 businesses. And geographic location, that has 00:06:42.089 --> 00:06:45.110 to play a huge role in diversification. Oh, an 00:06:45.110 --> 00:06:47.689 absolutely massive role. Your domestic equities. 00:06:47.689 --> 00:06:49.949 So for us, U .S. equities, they provide the core. 00:06:50.149 --> 00:06:52.230 But you have to look globally. You have developed 00:06:52.230 --> 00:06:55.370 markets. Europe. Right. And then you have the 00:06:55.370 --> 00:06:58.149 much higher risk, higher potential return categories 00:06:58.149 --> 00:07:01.329 of emerging and even frontier markets. And the 00:07:01.329 --> 00:07:03.350 benefit there is that their economies aren't 00:07:03.350 --> 00:07:05.990 moving in sync with ours. Exactly. The economic 00:07:05.990 --> 00:07:09.589 cycles, the currency risks, they are not perfectly 00:07:09.589 --> 00:07:11.629 tied to your home market. That's the diversification 00:07:11.629 --> 00:07:15.730 benefit right there. Okay. Next up, we have bonds 00:07:15.730 --> 00:07:18.329 or fixed income. So if stocks are the accelerator. 00:07:19.000 --> 00:07:21.480 Then bonds are the structural support. They're 00:07:21.480 --> 00:07:24.420 the brake. They are debt instruments. You're 00:07:24.420 --> 00:07:27.439 essentially lending money. And their main purpose. 00:07:28.139 --> 00:07:31.480 is capital preservation. So safety first. Safety, 00:07:31.500 --> 00:07:33.920 providing income, and this is the most important 00:07:33.920 --> 00:07:36.959 part, acting as that counter -cyclical stabilizer 00:07:36.959 --> 00:07:39.439 when your stocks are taking a nosedive. And we 00:07:39.439 --> 00:07:41.819 classify them by who's borrowing the money. Correct. 00:07:41.939 --> 00:07:44.060 You have government bonds, which are usually 00:07:44.060 --> 00:07:47.500 the safest, versus corporate bonds. And risk 00:07:47.500 --> 00:07:50.579 matters hugely here, too. How so? Well, you have 00:07:50.579 --> 00:07:52.959 your investment grade bonds, which are issued 00:07:52.959 --> 00:07:55.560 by very stable companies or governments. And 00:07:55.560 --> 00:07:57.439 then you have high yield bonds. Also known as 00:07:57.439 --> 00:08:00.000 junk bonds. Also known as junk bonds. Yes. They 00:08:00.000 --> 00:08:02.000 have to be much higher interest rates to compensate 00:08:02.000 --> 00:08:04.199 investors for the much greater risk of default. 00:08:04.459 --> 00:08:06.899 And the other factor is time, right? Duration. 00:08:07.019 --> 00:08:09.600 Yes. Duration, which we often simplify by just 00:08:09.600 --> 00:08:11.680 looking at the time frame. Short term, intermediate 00:08:11.680 --> 00:08:14.399 or long term maturity bonds. And the simple rule 00:08:14.399 --> 00:08:17.040 is? Shorter duration bonds generally have a lower 00:08:17.040 --> 00:08:19.500 yield. but they also have much lower interest 00:08:19.500 --> 00:08:23.420 rate risk. Okay, finally, the bedrock. Cash and 00:08:23.420 --> 00:08:26.439 cash equivalents. This is the truly defensive 00:08:26.439 --> 00:08:29.420 asset. This is your safety blanket. Think about 00:08:29.420 --> 00:08:32.259 standard liquid deposit accounts or money market 00:08:32.259 --> 00:08:34.179 funds. What's its function in the blueprint? 00:08:35.059 --> 00:08:38.179 Its main function is to provide liquidity and, 00:08:38.299 --> 00:08:41.240 crucially, optionality. Optionality. What do 00:08:41.240 --> 00:08:43.039 you mean? When markets are crashing all around 00:08:43.039 --> 00:08:45.720 you, having cash equivalents means you have dry 00:08:45.720 --> 00:08:48.580 powder. You have the ability to rebalance your 00:08:48.580 --> 00:08:51.860 portfolio and buy those risky assets, like stocks, 00:08:51.940 --> 00:08:55.059 when they're cheap, without being forced to sell 00:08:55.059 --> 00:08:57.700 other things that are also falling in value. 00:08:57.799 --> 00:09:00.019 It's the buy low part of the equation. It enables 00:09:00.019 --> 00:09:02.580 the buy low part. Without it, you're just a forced 00:09:02.580 --> 00:09:05.059 seller. Okay, let's look beyond the standard 00:09:05.059 --> 00:09:07.620 60 -40 mix for a minute. Let's talk about the 00:09:07.620 --> 00:09:10.200 universe of alternative assets. Why are these 00:09:10.200 --> 00:09:12.820 suddenly so popular, especially in big institutional 00:09:12.820 --> 00:09:15.649 portfolios? Well, they're popular for one main 00:09:15.649 --> 00:09:18.350 reason. They are actively sought out for their 00:09:18.350 --> 00:09:20.490 low correlation with the traditional stock and 00:09:20.490 --> 00:09:22.529 bond markets. So they zig when everything else 00:09:22.529 --> 00:09:25.129 sags. That's the hope. They offer different kinds 00:09:25.129 --> 00:09:27.669 of risk premiums. We can probably group these 00:09:27.669 --> 00:09:30.769 alternatives into three major functional buckets 00:09:30.769 --> 00:09:33.269 just to keep it simple. OK, bucket one. Bucket 00:09:33.269 --> 00:09:35.669 one is tangible assets and inflation hedges. 00:09:35.830 --> 00:09:38.389 This includes physical things like precious metals. 00:09:38.590 --> 00:09:41.570 Gold is the classic example. or even valuable 00:09:41.570 --> 00:09:44.669 collectibles like fine art or rare stamps. And 00:09:44.669 --> 00:09:46.830 their value isn't tied to corporate profits. 00:09:47.110 --> 00:09:49.929 Right. Their performance is often linked to things 00:09:49.929 --> 00:09:53.009 like inflation expectations or general economic 00:09:53.009 --> 00:09:55.789 uncertainty. So they're a direct hedge against 00:09:55.789 --> 00:09:58.769 your currency losing value, not against the stock 00:09:58.769 --> 00:10:00.990 market's performance. Makes sense. Bucket number 00:10:00.990 --> 00:10:04.139 two. Real assets. This is primarily real estate 00:10:04.139 --> 00:10:06.419 commercial or residential. You can own it directly 00:10:06.419 --> 00:10:09.879 or through more liquid things like REITs, which 00:10:09.879 --> 00:10:11.679 are real estate investment trusts. You can buy 00:10:11.679 --> 00:10:14.580 them just like a stock. Exactly. And this bucket 00:10:14.580 --> 00:10:16.559 also includes things like infrastructure projects, 00:10:16.899 --> 00:10:19.700 pipelines, airports, utilities. And the appeal 00:10:19.700 --> 00:10:22.879 there is steady cash flow. Stable, often inflation 00:10:22.879 --> 00:10:25.419 -adjusted cash flows. Again, a very different 00:10:25.419 --> 00:10:27.879 risk profile than public company stocks. All 00:10:27.879 --> 00:10:29.840 right. And the final bucket. This is where things 00:10:29.840 --> 00:10:33.080 get a bit more specialized. This is the deep 00:10:33.080 --> 00:10:35.500 end of the pool, complex financial instruments 00:10:35.500 --> 00:10:38.820 and private markets. This is where the big endowments 00:10:38.820 --> 00:10:41.460 and pension funds really operate. It includes 00:10:41.460 --> 00:10:43.840 venture capital and private equity. So investing 00:10:43.840 --> 00:10:46.440 directly in companies that aren't on the stock 00:10:46.440 --> 00:10:49.139 market. Yes. And it also includes complex derivatives 00:10:49.139 --> 00:10:52.360 like options and futures or some very, very specialized 00:10:52.360 --> 00:10:54.600 instruments. Speaking of specialized, I want 00:10:54.600 --> 00:10:57.240 to go back to that bizarre example we found in 00:10:57.240 --> 00:11:00.129 the source material. The catastrophe bond. Oh, 00:11:00.169 --> 00:11:02.269 that's a fascinating one. Explain why it's the 00:11:02.269 --> 00:11:05.330 perfect example of a truly non -correlated asset. 00:11:05.690 --> 00:11:09.210 OK, so a catastrophe bond or a cat bond is a 00:11:09.210 --> 00:11:11.929 debt security. But the repayment of your principal 00:11:11.929 --> 00:11:14.929 is tied to a specific non -market related event, 00:11:15.090 --> 00:11:18.110 like a major earthquake in California or a Category 00:11:18.110 --> 00:11:20.570 5 hurricane hitting Florida. So your investment 00:11:20.570 --> 00:11:22.830 is basically a bet on the weather. Or on geology, 00:11:23.090 --> 00:11:25.750 yes. You get a very high yield for taking on 00:11:25.750 --> 00:11:28.970 that risk. But think about it. The stock market 00:11:28.970 --> 00:11:31.870 could be having its best year in a decade. But 00:11:31.870 --> 00:11:34.649 if a massive hurricane makes landfall in Miami, 00:11:34.929 --> 00:11:37.850 you could lose all your principal. And the opposite 00:11:37.850 --> 00:11:40.809 is true. The opposite is true. The market could 00:11:40.809 --> 00:11:44.090 crash 30%. But if the weather is calm and the 00:11:44.090 --> 00:11:46.730 earth doesn't shake, your bond is perfectly fine. 00:11:46.970 --> 00:11:49.789 Its risk driver has absolutely zero correlation 00:11:49.789 --> 00:11:53.820 with the S &P 500. Wow. That really does illustrate 00:11:53.820 --> 00:11:56.220 the point perfectly. The goal of alternatives 00:11:56.220 --> 00:11:58.539 is to find risk that isn't tied to the global 00:11:58.539 --> 00:12:01.000 economy. That's the holy grail for diversification. 00:12:01.399 --> 00:12:03.700 OK, so now that we have all the assets, we need 00:12:03.700 --> 00:12:05.679 a way to classify them based on their behavior, 00:12:05.799 --> 00:12:07.679 because that ties directly into the strategies 00:12:07.679 --> 00:12:09.440 we're about to get into. And that brings us to 00:12:09.440 --> 00:12:12.259 the industry classification context. It's a functional 00:12:12.259 --> 00:12:14.759 way of looking at stocks, often using something 00:12:14.759 --> 00:12:17.440 like the Morningstar X -ray structure to see 00:12:17.440 --> 00:12:20.220 how entire sectors of the economy respond to 00:12:20.220 --> 00:12:22.259 the business cycle. And this is critical for 00:12:22.259 --> 00:12:24.519 the more active allocation strategies. Absolutely 00:12:24.519 --> 00:12:27.340 essential. So the first group is defensive. Right. 00:12:27.519 --> 00:12:29.200 Defensive sectors are the ones that maintain 00:12:29.200 --> 00:12:30.980 relatively stable demand, no matter what the 00:12:30.980 --> 00:12:33.700 broader economy is doing. These are the essentials. 00:12:34.059 --> 00:12:36.919 Things we can't live without. Exactly. Consumer 00:12:36.919 --> 00:12:40.559 staples, so groceries, toothpaste, cleaning products, 00:12:41.200 --> 00:12:44.980 health care and utilities. When people get nervous 00:12:44.980 --> 00:12:47.000 about a recession, they tend to pile into defensive 00:12:47.000 --> 00:12:49.240 stocks looking for safety. OK, what's the next 00:12:49.240 --> 00:12:52.740 group? The sensitive group. These sectors are, 00:12:52.860 --> 00:12:55.679 well, sensitive to the general pace of the economy. 00:12:56.000 --> 00:12:59.059 They react pretty sharply to changes in sentiment 00:12:59.059 --> 00:13:01.659 or small shifts in interest rates. So what's 00:13:01.659 --> 00:13:04.539 in this bucket? This includes energy, industrials, 00:13:04.539 --> 00:13:07.179 technology, and telecommunications. They're not 00:13:07.179 --> 00:13:09.620 exactly recession -proof, but they are generally 00:13:09.620 --> 00:13:12.539 less volatile than our last category. In that 00:13:12.539 --> 00:13:14.840 last category, the most volatile players are 00:13:14.840 --> 00:13:17.820 the cyclical assets. Correct. Cyclical sectors 00:13:17.820 --> 00:13:20.340 are entirely dependent on the economic boom cycle. 00:13:20.539 --> 00:13:22.919 They thrive when people have a lot of disposable 00:13:22.919 --> 00:13:25.840 income and when credit is cheap and easy to get. 00:13:25.940 --> 00:13:29.299 Consumer discretionary luxury goods, travel, 00:13:29.500 --> 00:13:33.360 new cars, basic materials, mining, construction 00:13:33.360 --> 00:13:36.460 materials, financial banks, brokerage firms. 00:13:37.230 --> 00:13:40.769 and real estate. So if you bet heavily on cyclicals, 00:13:40.769 --> 00:13:43.529 you are making a big bet on continued economic 00:13:43.529 --> 00:13:46.350 expansion. A very big bet. The moment you start 00:13:46.350 --> 00:13:48.450 classifying assets like this, you're already 00:13:48.450 --> 00:13:50.629 thinking about strategy. Which is the perfect 00:13:50.629 --> 00:13:53.490 transition point for us. Exactly. Understanding 00:13:53.490 --> 00:13:56.090 those behavioral buckets, defensive, sensitive, 00:13:56.269 --> 00:13:59.529 cyclical, it really is the foundation for applying 00:13:59.529 --> 00:14:01.990 the four major allocation strategies we're going 00:14:01.990 --> 00:14:04.289 to talk about. And these strategies, they mostly 00:14:04.289 --> 00:14:06.990 differ based on their time horizon and I guess 00:14:06.990 --> 00:14:08.830 how much they're willing to fiddle with the plan. 00:14:09.029 --> 00:14:11.110 Their willingness to react to market noise is 00:14:11.110 --> 00:14:12.850 a good way to put it. OK, let's start with the 00:14:12.850 --> 00:14:15.110 most disciplined approach, the one that's most 00:14:15.110 --> 00:14:18.110 often recommended for long term investors. Strategic 00:14:18.110 --> 00:14:20.909 asset allocation. Strategic AA is the anchor. 00:14:21.289 --> 00:14:23.649 Its one and only goal is to create an asset mix 00:14:23.649 --> 00:14:26.450 that targets the optimal balance between expected 00:14:26.450 --> 00:14:29.509 risk and return over a very long time horizon. 00:14:29.730 --> 00:14:32.330 We're talking decades. We're talking 20, 30 years. 00:14:32.409 --> 00:14:35.610 Yes. And its key characteristic is stability. 00:14:36.360 --> 00:14:39.440 It is almost entirely agnostic to what the market 00:14:39.440 --> 00:14:41.779 is doing this month or this year. Okay, so let 00:14:41.779 --> 00:14:44.360 me see if I have this right. If I decide my long 00:14:44.360 --> 00:14:47.580 -term plan requires, say, a 70 % stock and 30 00:14:47.580 --> 00:14:50.220 % bond mix based on my age and when I want to 00:14:50.220 --> 00:14:52.779 retire, I just set that policy and stick with 00:14:52.779 --> 00:14:55.080 it. You stick with it. Yeah. Regardless of whether 00:14:55.080 --> 00:14:57.539 you think the stock market is overvalued or undervalued 00:14:57.539 --> 00:14:59.360 this quarter. The set it and forget it approach. 00:14:59.559 --> 00:15:02.679 It's often called that. But the only active management 00:15:02.679 --> 00:15:05.129 you're really doing is rebalancing. Which is? 00:15:05.450 --> 00:15:07.370 Selling the assets that have grown too much. 00:15:07.490 --> 00:15:09.490 Let's say stocks have had a great run and now 00:15:09.490 --> 00:15:12.710 they're 75 % of your portfolio. And you use that 00:15:12.710 --> 00:15:15.570 money to buy the assets that have shrunk. the 00:15:15.570 --> 00:15:18.149 bonds that are now at 25 % to pull the whole 00:15:18.149 --> 00:15:20.610 thing back to your original 70 -30 target. That 00:15:20.610 --> 00:15:22.629 sounds like it forces you to sell high and buy 00:15:22.629 --> 00:15:26.149 low. It's a systematic, disciplined way to force 00:15:26.149 --> 00:15:28.470 yourself to sell high and buy low. It's a crucial 00:15:28.470 --> 00:15:30.610 behavioral safeguard. Okay, that makes sense. 00:15:30.710 --> 00:15:33.009 But what if the long -term fundamentals of the 00:15:33.009 --> 00:15:35.029 economy itself change? That feels different than 00:15:35.029 --> 00:15:37.509 just a market correction. And that is exactly 00:15:37.509 --> 00:15:40.009 where dynamic asset allocation comes in. Gus, 00:15:40.009 --> 00:15:42.029 how is it different? It's similar to strategic 00:15:42.029 --> 00:15:44.809 because it's still built for the long haul. It 00:15:44.809 --> 00:15:47.529 maintains exposure to the same core asset classes. 00:15:48.250 --> 00:15:51.629 But the key difference is that dynamic portfolios 00:15:51.629 --> 00:15:54.950 will adjust their postures over time. In reaction 00:15:54.950 --> 00:15:58.029 to what? In reaction to significant structural 00:15:58.029 --> 00:16:00.190 shifts in the economic environment. Give me an 00:16:00.190 --> 00:16:02.409 example of a structural shift, not just daily 00:16:02.409 --> 00:16:05.080 volatility. Think about multi -year changes. 00:16:05.240 --> 00:16:07.419 A great example would be if central banks around 00:16:07.419 --> 00:16:10.059 the world commit to a decade of near zero interest 00:16:10.059 --> 00:16:13.179 rates. Which they did. Which they did. That fundamentally 00:16:13.179 --> 00:16:15.820 alters the expected long -term return and the 00:16:15.820 --> 00:16:19.519 risk profile of fixed income, of bonds. A dynamic 00:16:19.519 --> 00:16:21.759 manager might see that and decide to slightly 00:16:21.759 --> 00:16:24.419 decrease their long -term bond allocation and 00:16:24.419 --> 00:16:26.320 maybe increase their allocation to some alternative 00:16:26.320 --> 00:16:29.200 assets to try and compensate for that lost yield 00:16:29.200 --> 00:16:32.139 potential. So they're reacting to big tectonic 00:16:32.139 --> 00:16:35.240 shifts in economic regimes. Exactly. Not just 00:16:35.240 --> 00:16:37.480 whether the S &P 500 is up or down this week. 00:16:37.700 --> 00:16:41.460 Okay. So strategic ignores the noise. Dynamic 00:16:41.460 --> 00:16:44.379 adapts to the tectonic plates. Now we get to 00:16:44.379 --> 00:16:46.100 the approach that seems to live entirely in the 00:16:46.100 --> 00:16:49.299 noise. Tactical asset allocation. That's a perfect 00:16:49.299 --> 00:16:52.000 description. Tactical AA is really the active 00:16:52.000 --> 00:16:54.480 traders game. It's designed to try and capture 00:16:54.480 --> 00:16:57.620 what are perceived to be short -term mispricings 00:16:57.620 --> 00:17:00.320 or temporary market imbalances. So they're trying 00:17:00.320 --> 00:17:02.700 to time the market. In a very deliberate, systematic 00:17:02.700 --> 00:17:06.240 way. The goal is to move the portfolio into specific 00:17:06.240 --> 00:17:10.319 assets or sectors or even regions that they believe 00:17:10.319 --> 00:17:13.099 will outperform over the next, say, six to 18 00:17:13.099 --> 00:17:15.680 months. OK, so if a tactical manager believes 00:17:15.680 --> 00:17:18.119 a recession is imminent, what do they do that 00:17:18.119 --> 00:17:20.099 a strategic one wouldn't? Well, the strategic 00:17:20.099 --> 00:17:22.480 portfolio, the 70 -30, it does nothing. It sticks 00:17:22.480 --> 00:17:24.779 to the plan. Right. The tactical portfolio seeing 00:17:24.779 --> 00:17:26.920 a recession on the horizon might slash its equity 00:17:26.920 --> 00:17:30.180 allocation from 70 % all the way down to 40%. 00:17:30.180 --> 00:17:33.339 It might increase its cash position to 30 % and 00:17:33.339 --> 00:17:35.420 shift the remaining stocks almost entirely into 00:17:35.420 --> 00:17:37.660 defensive sectors like utilities and health care. 00:17:37.720 --> 00:17:39.859 So they can make huge moves. They are free to 00:17:39.859 --> 00:17:42.000 move entirely in and out of their core asset 00:17:42.000 --> 00:17:44.619 classes, all in the search for a temporary advantage. 00:17:45.289 --> 00:17:48.049 The big risk, of course, is that you're constantly 00:17:48.049 --> 00:17:51.049 citing the tendency to get it wrong, to buy high 00:17:51.049 --> 00:17:53.470 and sell low because of poor timing. That sounds 00:17:53.470 --> 00:17:56.230 exhausting and probably really expensive with 00:17:56.230 --> 00:17:58.170 all that trading. Yeah, it can be both. Which 00:17:58.170 --> 00:18:00.690 leads us to what sounds like a smart blend of 00:18:00.690 --> 00:18:03.529 these ideas. Core satellite asset allocation. 00:18:03.930 --> 00:18:06.829 Yes, core satellite is a hybrid approach. It's 00:18:06.829 --> 00:18:09.349 built specifically to get some of that opportunistic 00:18:09.349 --> 00:18:12.910 potential while mitigating the huge risk of tactical 00:18:12.910 --> 00:18:16.710 errors. It tries to balance stability with opportunism. 00:18:16.750 --> 00:18:19.130 How does it contain the risk? The structure itself 00:18:19.130 --> 00:18:21.029 contains the risk. The core of the portfolio 00:18:21.029 --> 00:18:23.730 is the strategic element. It makes up the vast 00:18:23.730 --> 00:18:26.170 majority of the portfolio, maybe 70 or 80 percent. 00:18:26.349 --> 00:18:28.809 And that core is? It's highly diversified, typically 00:18:28.809 --> 00:18:31.890 very low cost, often passively managed, and it's 00:18:31.890 --> 00:18:33.829 completely dedicated to that long -term risk 00:18:33.829 --> 00:18:36.529 profile. It's the anchor. And the other 20 percent? 00:18:36.750 --> 00:18:38.230 That's the satellite portion. And that's where 00:18:38.230 --> 00:18:40.630 you can make your dynamic or your tactical adjustments. 00:18:41.029 --> 00:18:44.299 It's your play money. So if your tactical bet 00:18:44.299 --> 00:18:47.000 on emerging markets goes wrong. The core of your 00:18:47.000 --> 00:18:49.640 investment is protected and just keeps compounding 00:18:49.640 --> 00:18:52.119 away. It lets an investor try to seek alpha, 00:18:52.259 --> 00:18:55.400 that's excess returns, without betting the entire 00:18:55.400 --> 00:18:57.640 farm on their ability to predict the future. 00:18:57.880 --> 00:19:00.039 It sounds like the best of both worlds. It can 00:19:00.039 --> 00:19:02.519 be, but only if the investor maintains really 00:19:02.519 --> 00:19:04.720 strict discipline to keep that core dominant. 00:19:05.160 --> 00:19:07.299 It's an admission that while tactical skill can 00:19:07.299 --> 00:19:10.079 sometimes add value, the overall structure, the 00:19:10.079 --> 00:19:13.259 core AA, has to remain the primary driver of 00:19:13.259 --> 00:19:15.660 the portfolio's long -term return and volatility. 00:19:15.960 --> 00:19:18.599 All right, now we get to it, the great intellectual 00:19:18.599 --> 00:19:20.700 friction point in modern finance, the numbers 00:19:20.700 --> 00:19:23.319 that, well... Everyone seems to know, but almost 00:19:23.319 --> 00:19:25.819 nobody correctly understands. Yes. We are talking 00:19:25.819 --> 00:19:28.720 about the BHB study, Brinson, Hood, and B. Bauer 00:19:28.720 --> 00:19:31.299 from 1986, the study that gave birth to that 00:19:31.299 --> 00:19:34.599 infamous 93 .6 % claim. So this is basically 00:19:34.599 --> 00:19:36.660 the origin story for the idea that your strategy 00:19:36.660 --> 00:19:38.660 matters way more than your stock picking. It 00:19:38.660 --> 00:19:41.500 is. They looked at 91 large U .S. pension funds 00:19:41.500 --> 00:19:45.559 over a decade, from 1974 to 1983, and they asked 00:19:45.559 --> 00:19:48.200 a very simple question. How much of these funds' 00:19:48.380 --> 00:19:51.279 quarterly performance was because of their policy 00:19:51.279 --> 00:19:54.369 decision? Their asset allocation mix versus their 00:19:54.369 --> 00:19:57.069 active decisions. You know, the specific stocks 00:19:57.069 --> 00:19:59.390 and bonds they picked and their market timing. 00:19:59.569 --> 00:20:01.970 OK. And how on earth did they separate the two? 00:20:02.130 --> 00:20:04.509 How do you isolate the policy? They ran a thought 00:20:04.509 --> 00:20:06.970 experiment, a clever one. They took the actual 00:20:06.970 --> 00:20:09.470 returns from these actively managed pension funds 00:20:09.470 --> 00:20:12.970 and they hypothetically replaced all the individual 00:20:12.970 --> 00:20:16.930 holdings, every stock, every bond, with simple 00:20:16.930 --> 00:20:19.809 passive market indexes that corresponded to the 00:20:19.809 --> 00:20:22.430 fund's asset allocation policy. So they basically 00:20:22.430 --> 00:20:25.049 stripped out the manager's skill or lack thereof 00:20:25.049 --> 00:20:27.150 completely. Completely. And what was the headline 00:20:27.150 --> 00:20:29.650 finding from that? There were two big ones. First, 00:20:29.789 --> 00:20:32.049 the passively indexed hypothetical quarterly 00:20:32.049 --> 00:20:34.390 return series was actually higher than what the 00:20:34.390 --> 00:20:36.529 actively managed funds really returned. And that 00:20:36.529 --> 00:20:38.029 was before you even accounted for management 00:20:38.029 --> 00:20:41.440 fees. Wow. So the managers, on average, were 00:20:41.440 --> 00:20:43.660 actually subtracting value during that period. 00:20:43.859 --> 00:20:46.819 Emphatically, yes. But the finding that really 00:20:46.819 --> 00:20:49.519 changed the industry was the statistical relationship 00:20:49.519 --> 00:20:52.180 they found between the two return series. The 00:20:52.180 --> 00:20:55.140 actual returns versus the passive policy returns. 00:20:55.420 --> 00:20:57.240 Exactly. The statistical correlation between 00:20:57.240 --> 00:21:00.740 them was massive. It was 96 .7%. And here's the 00:21:00.740 --> 00:21:03.079 number that has echoed through finance ever since. 00:21:03.799 --> 00:21:07.339 The shared variance was 93 .6%. And they did 00:21:07.339 --> 00:21:09.420 a follow -up study, right? They did, in 1991. 00:21:09.720 --> 00:21:12.339 And it confirmed a very similar shared variance 00:21:12.339 --> 00:21:14.980 of 91 .5%. Okay, this is where the confusion 00:21:14.980 --> 00:21:18.279 begins. Because when people hear 93 .6 % shared 00:21:18.279 --> 00:21:21.480 variance, they immediately conclude, aha, asset 00:21:21.480 --> 00:21:24.859 allocation explains 93 .6 % of my total investment 00:21:24.859 --> 00:21:27.700 return. They do. But if that were actually true, 00:21:27.859 --> 00:21:30.799 why would active managers or strategists or analysts 00:21:30.799 --> 00:21:33.220 even exist? It would all be pointless. It would 00:21:33.220 --> 00:21:36.049 be. And it's because that conclusion is a fundamental 00:21:36.049 --> 00:21:38.930 statistical misinterpretation, especially when 00:21:38.930 --> 00:21:41.049 you apply it to your cumulative wealth over time. 00:21:41.170 --> 00:21:43.269 So what does the statistic actually show? It 00:21:43.269 --> 00:21:45.329 demonstrates the similarity of the two return 00:21:45.329 --> 00:21:47.589 series, especially in terms of their volatility 00:21:47.589 --> 00:21:50.109 and their movement from quarter to quarter. The 00:21:50.109 --> 00:21:51.630 original authors themselves, they had to come 00:21:51.630 --> 00:21:53.769 out later and clarify that their focus was always 00:21:53.769 --> 00:21:56.410 on correlation and volatility, not on explaining 00:21:56.410 --> 00:21:59.109 long -term cumulative performance. Correlation 00:21:59.109 --> 00:22:01.529 does not equal performance explanation. Not in 00:22:01.529 --> 00:22:03.740 this context, no. And this, of course, led to 00:22:03.740 --> 00:22:05.920 some major pushback. I'm thinking of William 00:22:05.920 --> 00:22:09.240 Jahnke's famous paper, The Asset Allocation Hoax. 00:22:09.579 --> 00:22:12.640 What was his main criticism? Jahnke's core argument 00:22:12.640 --> 00:22:16.799 was that using quarterly data artificially inflates 00:22:16.799 --> 00:22:19.359 that correlation number. How so? Well, think 00:22:19.359 --> 00:22:21.680 about it. If you're comparing two very similar 00:22:21.680 --> 00:22:24.380 portfolios over a very short time frame, like 00:22:24.380 --> 00:22:27.000 three months, their movements are going to look 00:22:27.000 --> 00:22:29.119 incredibly similar just because they're both 00:22:29.119 --> 00:22:31.460 being buffeted by the same broad market forces. 00:22:32.119 --> 00:22:35.240 So using short -term data hides the small differences. 00:22:35.359 --> 00:22:39.059 It dampens the impact of small but compounding 00:22:39.059 --> 00:22:41.880 differences in return. If manager A and manager 00:22:41.880 --> 00:22:44.960 B both have a 60 -40 allocation, sure, their 00:22:44.960 --> 00:22:46.779 quarterly movements will look almost identical, 00:22:46.920 --> 00:22:50.279 maybe 96 % correlated. But if manager A has a 00:22:50.279 --> 00:22:53.900 0 .5 % lower annual cost over 20 years, or if 00:22:53.900 --> 00:22:55.599 they consistently make a slightly better call 00:22:55.599 --> 00:22:58.900 on just 1 % of the portfolio, those tiny differences 00:22:58.900 --> 00:23:01.740 compound into dramatically different final wealth 00:23:01.740 --> 00:23:04.200 totals. And the correlation metric just doesn't 00:23:04.200 --> 00:23:06.259 capture the power of that compounding over time. 00:23:06.500 --> 00:23:09.579 It doesn't. The volatility looks the same. But 00:23:09.579 --> 00:23:12.259 the final outcome is not. We need a better way 00:23:12.259 --> 00:23:15.440 to distinguish what AA really explains. Which 00:23:15.440 --> 00:23:17.740 brings us to Ibbotson and Kaplan, who stepped 00:23:17.740 --> 00:23:20.559 in with their 2000 study to provide a much clearer 00:23:20.559 --> 00:23:23.380 statistical breakdown. What did they find when 00:23:23.380 --> 00:23:27.000 they looked at 94 mutual funds? Well, first they 00:23:27.000 --> 00:23:29.619 found a similarly high correlation, a shared 00:23:29.619 --> 00:23:33.299 variance of about 81%. But their analytical distinction 00:23:33.299 --> 00:23:35.700 is really the Rosetta Stone for this whole debate. 00:23:36.000 --> 00:23:39.019 They separated the impact of AA into two distinct 00:23:39.019 --> 00:23:41.299 categories. OK, what were those two categories? 00:23:41.599 --> 00:23:43.599 OK, first they found that AA explained only about 00:23:43.599 --> 00:23:46.059 40 percent of the variation of returns across 00:23:46.059 --> 00:23:47.940 different funds. What does that mean, across 00:23:47.940 --> 00:23:50.420 funds? That 40 percent is the difference in returns 00:23:50.420 --> 00:23:54.099 you see between, say, Fund A that focuses on 00:23:54.099 --> 00:23:57.019 large cap stocks and Fund B that focuses on small 00:23:57.019 --> 00:23:59.819 cap stocks. The other 60 percent of the difference 00:23:59.819 --> 00:24:02.549 is due to the manager. active choices, stock 00:24:02.549 --> 00:24:04.890 selection, timing, and most importantly, costs. 00:24:05.269 --> 00:24:07.569 So strategy explains why the funds behave differently, 00:24:07.690 --> 00:24:10.130 but only accounts for 40 % of the performance 00:24:10.130 --> 00:24:12.029 difference between them. Right. But here was 00:24:12.029 --> 00:24:14.150 their second and absolutely critical finding. 00:24:14.430 --> 00:24:17.170 Which was? They found that AA explained virtually 00:24:17.170 --> 00:24:20.390 100 % of the level of a fund's returns. Wait, 00:24:20.470 --> 00:24:22.130 that sounds like a contradiction. How can it 00:24:22.130 --> 00:24:24.650 explain 100 % of the level, but only 40 % of 00:24:24.650 --> 00:24:26.569 the variation? It does sound tricky. Let's use 00:24:26.569 --> 00:24:29.710 a metaphor. Please. Imagine you decide to drive 00:24:29.710 --> 00:24:33.000 from New York to Los Angeles. Your asset allocation 00:24:33.000 --> 00:24:35.720 decision is your choice of vehicle. Are you going 00:24:35.720 --> 00:24:38.079 to take a high -speed sports car, let's call 00:24:38.079 --> 00:24:41.380 that an 80 % stock allocation, or a reliable 00:24:41.380 --> 00:24:44.599 low -risk van, a 20 % stock allocation? Okay, 00:24:44.680 --> 00:24:47.460 sports car is faster, more exciting, but more 00:24:47.460 --> 00:24:50.160 prone to accidents and uses expensive fuel. The 00:24:50.160 --> 00:24:53.240 van is slower but safer and more efficient. Perfect. 00:24:53.460 --> 00:24:55.859 The level of your return is the inherent speed 00:24:55.859 --> 00:24:58.299 limit of your chosen vehicle. The sports car 00:24:58.299 --> 00:25:00.400 level means you expect to arrive in, say, four 00:25:00.400 --> 00:25:02.980 days. The van level means you expect it to take 00:25:02.980 --> 00:25:05.900 six days. That basic expectation, the bulk of 00:25:05.900 --> 00:25:08.559 your journey's time, is 100 % dictated by which 00:25:08.559 --> 00:25:10.740 vehicle you chose at the start. Got it. So my 00:25:10.740 --> 00:25:13.480 choice of 70 % equity is that dictates my expected 00:25:13.480 --> 00:25:15.559 long -term return profile. That's the level. 00:25:15.869 --> 00:25:17.970 That is the level. Now, the variation, that's 00:25:17.970 --> 00:25:20.390 the 40%. That's whether one driver gets slightly 00:25:20.390 --> 00:25:23.130 better gas mileage or finds a faster route for 00:25:23.130 --> 00:25:25.670 a couple of hours or hits some unexpected traffic. 00:25:25.809 --> 00:25:27.710 It determines if I show up a few hours earlier 00:25:27.710 --> 00:25:30.869 or later than expected. Exactly. But it doesn't 00:25:30.869 --> 00:25:33.829 change the fundamental four -day versus six -day 00:25:33.829 --> 00:25:36.650 expectation that was set by the vehicle. The 00:25:36.650 --> 00:25:39.359 AA choice is about setting the expectation. That 00:25:39.359 --> 00:25:41.339 is a huge distinction. So the number we should 00:25:41.339 --> 00:25:44.660 really care about isn't the 93 .6 % volatility 00:25:44.660 --> 00:25:48.440 correlation. It's the 100 % impact that AA has 00:25:48.440 --> 00:25:51.559 on defining our long -term return level. Precisely. 00:25:51.559 --> 00:25:53.880 And that this idea was crystallized even further 00:25:53.880 --> 00:25:56.359 by Meir Statman's work, which looked at all this 00:25:56.359 --> 00:25:58.220 through the lens of the efficient frontier. The 00:25:58.220 --> 00:26:00.599 efficient frontier. That's the curve that maps 00:26:00.599 --> 00:26:03.140 out the best possible return for any given level 00:26:03.140 --> 00:26:05.980 of risk. It is. And Statman showed that strategic 00:26:05.980 --> 00:26:08.539 AA is simply choosing a point along that frontier. 00:26:09.150 --> 00:26:11.289 You pick a risk level you can tolerate, say 10 00:26:11.289 --> 00:26:14.329 % standard deviation, and you accept the corresponding 00:26:14.329 --> 00:26:16.670 expected return that the market offers for that 00:26:16.670 --> 00:26:19.609 risk. But tactical AA, the active approach, is 00:26:19.609 --> 00:26:21.210 trying to do something completely different. 00:26:21.450 --> 00:26:23.869 A tactical manager is trying to predict market 00:26:23.869 --> 00:26:26.730 anomalies. They are effectively trying to shift 00:26:26.730 --> 00:26:29.640 the entire efficient frontier upward. So they're 00:26:29.640 --> 00:26:32.519 saying? They're saying, for that same 10 % level 00:26:32.519 --> 00:26:35.380 of risk, I believe my temporary tactical moves 00:26:35.380 --> 00:26:37.640 can earn a higher return than what the market 00:26:37.640 --> 00:26:39.839 average offers. They're trying to move the whole 00:26:39.839 --> 00:26:43.400 possibility set. And did Statman's analysis show 00:26:43.400 --> 00:26:46.500 if that was possible? Did tactical skill add 00:26:46.500 --> 00:26:50.079 value? Hypothetically, yes, in a big way. Statman 00:26:50.079 --> 00:26:52.299 ran a simulation where a tactical advisor had 00:26:52.299 --> 00:26:54.799 perfect foresight. They knew exactly when to 00:26:54.799 --> 00:26:57.240 shift between stocks and bonds to maximize their 00:26:57.240 --> 00:26:59.539 gains. And what was the result? This perfect 00:26:59.539 --> 00:27:02.539 tactical advisor performed 8 .1 % better per 00:27:02.539 --> 00:27:05.359 year than the purely strategic set it and forget 00:27:05.359 --> 00:27:09.059 it approach. 8 .1 % annually. That's a game -changing 00:27:09.059 --> 00:27:12.140 amount of alpha. It's enormous. But here's the 00:27:12.140 --> 00:27:13.859 punchline, and it brings us right back to the 00:27:13.859 --> 00:27:16.359 discipline requirement. Even with that perfect 00:27:16.359 --> 00:27:19.160 tactical manager adding 8 .1 % of outperformance 00:27:19.160 --> 00:27:22.420 every single year, the boring, static, strategic 00:27:22.420 --> 00:27:26.240 AA policy still explained 89 .4 % of the return 00:27:26.240 --> 00:27:28.519 variance. So even with a perfect manager, the 00:27:28.519 --> 00:27:31.039 structure still governed the volatility. The 00:27:31.039 --> 00:27:33.519 structure still governed the volatility and the 00:27:33.519 --> 00:27:36.880 expectation. Tactical skill is incredibly valuable 00:27:36.880 --> 00:27:39.880 if you possess perfect foresight, but the strategic 00:27:39.880 --> 00:27:42.579 choice is still the dominant risk factor in your 00:27:42.579 --> 00:27:45.299 portfolio. OK, so the synthesis for you, the 00:27:45.299 --> 00:27:48.019 listener, is this. Asset allocation explains 00:27:48.019 --> 00:27:51.099 90 % or more of the volatility of your returns 00:27:51.099 --> 00:27:54.180 and basically 100 % of the expected level of 00:27:54.180 --> 00:27:56.579 your returns. It's your primary risk containment 00:27:56.579 --> 00:27:59.099 tool. But it does not explain your final ending 00:27:59.099 --> 00:28:01.500 wealth entirely. That's where things like timing 00:28:01.500 --> 00:28:04.640 mistakes, cost efficiency, and active compounding 00:28:04.640 --> 00:28:06.859 can add or subtract significant amounts over 00:28:06.859 --> 00:28:09.500 the decades. Let's just briefly wrap the academic 00:28:09.500 --> 00:28:12.000 side with a look at modern research, specifically 00:28:12.000 --> 00:28:14.759 the global market portfolio. Yes, this comes 00:28:14.759 --> 00:28:17.819 from work by Duswick, Lamb, and Swinkles. So 00:28:17.819 --> 00:28:19.980 what exactly is the global market portfolio? 00:28:20.259 --> 00:28:22.859 Why do researchers see it as the ultimate benchmark? 00:28:23.200 --> 00:28:26.640 The GMP is, in theory, the portfolio of the average 00:28:26.640 --> 00:28:29.119 investor in the entire world. It includes the 00:28:29.119 --> 00:28:31.259 relative value of every single globally traded 00:28:31.259 --> 00:28:33.539 asset, all the stocks, all the bonds, all the 00:28:33.539 --> 00:28:35.799 real estate, commodities, everything. So it's 00:28:35.799 --> 00:28:38.559 a total investable universe. It is. And because 00:28:38.559 --> 00:28:41.200 of that, many financial experts argue it's the 00:28:41.200 --> 00:28:44.160 optimal portfolio for the average, totally diversified 00:28:44.160 --> 00:28:46.579 investor who has no special information or insight. 00:28:46.839 --> 00:28:49.160 What does that optimal benchmark look like in 00:28:49.160 --> 00:28:51.299 terms of long -term returns? Well, their data 00:28:51.299 --> 00:28:55.099 shows that from 1960 all the way to 2017, the 00:28:55.099 --> 00:28:58.200 global market portfolio realized a compounded 00:28:58.200 --> 00:29:01.940 real return of 4 .45 % per year. Real return. 00:29:02.059 --> 00:29:04.119 So that's after inflation. After inflation. And 00:29:04.119 --> 00:29:06.440 it did that with a standard deviation or volatility 00:29:06.440 --> 00:29:10.859 of 11%. That 4 .45 % real return over nearly 00:29:10.859 --> 00:29:13.880 60 years, that feels like a really powerful anchor 00:29:13.880 --> 00:29:16.640 for setting long -term expectations. It is. And 00:29:16.640 --> 00:29:18.940 it also highlights the impact of those huge structural 00:29:18.940 --> 00:29:21.099 economic regimes we talked about. During the 00:29:21.099 --> 00:29:24.000 high inflation period from 1960 to 1979, the 00:29:24.000 --> 00:29:27.339 real return was only 3 .24 % per year. But then... 00:29:27.579 --> 00:29:29.619 But then during the disinflationary period from 00:29:29.619 --> 00:29:32.420 1980 to 2017, it jumped up to a really robust 00:29:32.420 --> 00:29:36.180 6 .01 % per year. Your asset allocation policy 00:29:36.180 --> 00:29:38.420 needs to be strong enough to survive those massive 00:29:38.420 --> 00:29:40.799 multi -decade shifts in economic reality. Okay, 00:29:40.839 --> 00:29:42.900 so we've established that asset allocation is 00:29:42.900 --> 00:29:45.759 all about structural control. It's about managing 00:29:45.759 --> 00:29:49.319 volatility. But a structure is completely useless 00:29:49.319 --> 00:29:52.099 without implementation. And implementation is 00:29:52.099 --> 00:29:55.880 governed by human emotion. Exactly. This shifts 00:29:55.880 --> 00:30:00.400 us from the quantitative theory to the behavioral 00:30:00.400 --> 00:30:03.380 reality. And that starts with the single most 00:30:03.380 --> 00:30:07.160 important decision, the return versus risk tradeoff. 00:30:07.259 --> 00:30:09.839 This is the choice of the vehicle we talked about, 00:30:09.960 --> 00:30:12.950 the sports car versus the van. The stock versus 00:30:12.950 --> 00:30:15.789 bond ratio is absolutely paramount. It determines 00:30:15.789 --> 00:30:17.690 how much potential long term growth you're aiming 00:30:17.690 --> 00:30:20.630 for versus how much inevitable short term pain 00:30:20.630 --> 00:30:22.950 you must be willing to endure to get there. And 00:30:22.950 --> 00:30:25.009 it is so easy to say, oh, I have a high risk 00:30:25.009 --> 00:30:27.049 tolerance when the market is going up 20 percent 00:30:27.049 --> 00:30:29.470 a year. So easy. But the sources we read really 00:30:29.470 --> 00:30:31.930 stress that your true risk tolerance is only 00:30:31.930 --> 00:30:34.539 revealed under duress. when you're losing money. 00:30:34.700 --> 00:30:37.720 That is the hard truth of investing. Simply buying 00:30:37.720 --> 00:30:39.799 a high stock allocation without realistically 00:30:39.799 --> 00:30:42.240 modeling what the worst case scenario looks and 00:30:42.240 --> 00:30:45.180 feels like can lead to the very outcome AA is 00:30:45.180 --> 00:30:46.920 designed to prevent, which is panic selling. 00:30:47.799 --> 00:30:50.759 The key is to choose an allocation that you can 00:30:50.759 --> 00:30:52.980 mentally and emotionally hold on to through a 00:30:52.980 --> 00:30:55.670 severe market drawdown. Let's use some dramatic 00:30:55.670 --> 00:30:58.750 data to illustrate this. Let's look at the 2000 00:30:58.750 --> 00:31:02.190 to 2002 bear market. This was the dot -com bust, 00:31:02.369 --> 00:31:05.450 a brutal period for tech and growth stocks. That 00:31:05.450 --> 00:31:08.029 period perfectly isolates the critical importance 00:31:08.029 --> 00:31:10.910 of the stock bond mix. Let's consider the highly 00:31:10.910 --> 00:31:13.630 aggressive investor, the one who chose the growth 00:31:13.630 --> 00:31:16.440 -focused sports car. Let's say a portfolio of 00:31:16.440 --> 00:31:19.480 80 % stock and 20 % bond. Over that three -year 00:31:19.480 --> 00:31:22.119 bear market, that portfolio suffered a cumulative 00:31:22.119 --> 00:31:25.819 return of negative 34 .35%. And that's after 00:31:25.819 --> 00:31:28.460 inflation. A third of your money. gone. That 00:31:28.460 --> 00:31:30.279 is the moment where behavioral discipline just 00:31:30.279 --> 00:31:32.059 shatters. That's when an investor starts reading 00:31:32.059 --> 00:31:34.059 scary headlines and panics, locking in those 00:31:34.059 --> 00:31:36.380 losses forever. Now let's contrast that with 00:31:36.380 --> 00:31:38.599 a conservative investor, the one who valued stability 00:31:38.599 --> 00:31:41.180 and chose the van, a portfolio of 20 percent 00:31:41.180 --> 00:31:43.660 stock and 80 percent bond. OK, what happened 00:31:43.660 --> 00:31:45.940 to them? That portfolio ended up with a positive 00:31:45.940 --> 00:31:48.799 cumulative return of plus six point two nine 00:31:48.799 --> 00:31:51.099 percent after inflation during the exact same 00:31:51.099 --> 00:31:54.539 period. Wow. A 41 percentage point difference 00:31:54.539 --> 00:31:57.569 in capital preservation. Just from that foundational 00:31:57.569 --> 00:32:01.069 choice of the AA blueprint, the 80 -20 investor 00:32:01.069 --> 00:32:03.930 was subjected to genuine financial trauma. While 00:32:03.930 --> 00:32:07.109 the 20 -80 investor actually made money simply 00:32:07.109 --> 00:32:09.809 by staying invested, that is volatility management 00:32:09.809 --> 00:32:12.339 in action. But we have to respect the tradeoff. 00:32:12.420 --> 00:32:15.079 Absolutely. Because if we look forward, the projected 00:32:15.079 --> 00:32:17.720 10 -year cumulative returns are starkly different. 00:32:17.880 --> 00:32:21.900 That 80 -20 portfolio might project a 52 % cumulative 00:32:21.900 --> 00:32:24.980 gain, while the 20 -80 portfolio only projects 00:32:24.980 --> 00:32:28.410 a 24 % gain. So the aggressive investor is accepting 00:32:28.410 --> 00:32:31.390 that massive short term pain for the potential 00:32:31.390 --> 00:32:34.009 of doubling their long term wealth gain. Exactly. 00:32:34.130 --> 00:32:36.529 The true art of AA is defining the amount of 00:32:36.529 --> 00:32:38.269 pain you can stomach without selling to make 00:32:38.269 --> 00:32:40.430 sure you stay on the road long enough to actually 00:32:40.430 --> 00:32:42.430 reach that higher potential reward. Which brings 00:32:42.430 --> 00:32:45.069 us to the next operational aspect. If we get 00:32:45.069 --> 00:32:47.130 the allocation right, what about the specific 00:32:47.130 --> 00:32:49.769 funds we choose within that allocation? A very 00:32:49.769 --> 00:32:51.990 important question. So let's talk about performance 00:32:51.990 --> 00:32:54.690 indicators and specifically the reliability of 00:32:54.690 --> 00:32:57.490 low cost. There was a study by McGuigan that 00:32:57.490 --> 00:33:00.329 showed how hard it is to just pick a winning 00:33:00.329 --> 00:33:03.170 fund based on its past results. It's incredibly 00:33:03.170 --> 00:33:06.089 difficult. McGuigan looked at all the funds that 00:33:06.089 --> 00:33:09.130 were the top 25 percent of performance during 00:33:09.130 --> 00:33:12.960 the decade. From 1983 to 1993. The winners. The 00:33:12.960 --> 00:33:14.759 winners. Then they followed them for the next 00:33:14.759 --> 00:33:18.619 decade. And they found that only 28 .57 % of 00:33:18.619 --> 00:33:21.339 those top funds managed to stay in the top quartile. 00:33:21.440 --> 00:33:23.200 So more than two -thirds of the winners became 00:33:23.200 --> 00:33:25.299 average or worse. They dropped significantly 00:33:25.299 --> 00:33:28.569 in rank. Past performance is a highly unreliable 00:33:28.569 --> 00:33:31.430 indicator of future results. So if past success 00:33:31.430 --> 00:33:34.430 is unreliable, what factor is consistently reliable? 00:33:34.849 --> 00:33:36.750 The conclusion from John Bogle, which really 00:33:36.750 --> 00:33:38.650 applies universally to structured investing, 00:33:38.930 --> 00:33:41.470 was that low cost was a more reliable indicator 00:33:41.470 --> 00:33:44.170 of superior performance. How so? When he studied 00:33:44.170 --> 00:33:46.549 funds, the lowest cost quartile consistently 00:33:46.549 --> 00:33:48.670 delivered the best performance, and the highest 00:33:48.670 --> 00:33:50.730 cost quartile consistently delivered the worst. 00:33:51.069 --> 00:33:53.829 The reason is simple. Cost is the only predictive 00:33:53.829 --> 00:33:56.400 factor you know for certain in advance. Every 00:33:56.400 --> 00:33:58.539 dollar you pay in fees is a dollar that can't 00:33:58.539 --> 00:34:01.400 compound for you. Exactly. Regardless of how 00:34:01.400 --> 00:34:03.359 brilliant the tactical manager believes they 00:34:03.359 --> 00:34:06.359 are, when your asset allocation is dictating 00:34:06.359 --> 00:34:08.659 the overwhelming majority of your return level 00:34:08.659 --> 00:34:11.579 and your volatility, then minimizing the cost 00:34:11.579 --> 00:34:14.639 friction on that plan becomes paramount. The 00:34:14.639 --> 00:34:17.460 AA plan is the blueprint and cost is the tax 00:34:17.460 --> 00:34:19.440 you pay on that blueprint. A perfect way to put 00:34:19.440 --> 00:34:22.099 it. This leads us to our final and I think most 00:34:22.099 --> 00:34:25.659 crucial discussion point. The nine core problems 00:34:25.659 --> 00:34:28.920 with asset allocation. These are the real -world, 00:34:28.960 --> 00:34:31.719 human, and practical challenges that can completely 00:34:31.719 --> 00:34:34.980 derail even a theoretically perfect AA plan. 00:34:35.300 --> 00:34:37.519 We've established the failure is usually behavioral, 00:34:37.699 --> 00:34:39.840 not mathematical. This is where the rubber meets 00:34:39.840 --> 00:34:42.179 the road. Right. And the most important takeaway 00:34:42.179 --> 00:34:44.480 here is that the plan is only as good as the 00:34:44.480 --> 00:34:47.480 investor's ability to actually stick to it. 100%. 00:34:47.480 --> 00:34:49.840 Let's start with the unavoidable elephant in 00:34:49.840 --> 00:34:52.659 the room, behavioral bias. Investor behavior 00:34:52.659 --> 00:34:56.059 is just. It's fundamentally biased. We're driven 00:34:56.059 --> 00:34:59.179 by fear and greed. We anchor to recent outcomes. 00:34:59.400 --> 00:35:02.360 We exhibit hurting behavior. We follow the crowd. 00:35:03.119 --> 00:35:06.119 And we feel the pain of a loss far more acutely 00:35:06.119 --> 00:35:08.780 than the joy of an equivalent gain. And this 00:35:08.780 --> 00:35:11.739 is a direct challenge to the disciplined rebalancing 00:35:11.739 --> 00:35:14.880 that a strategic AA plan requires. It's a huge 00:35:14.880 --> 00:35:17.579 challenge. When stocks are soaring, every instinct 00:35:17.579 --> 00:35:20.559 in your body is screaming to buy more, not to 00:35:20.559 --> 00:35:22.760 sell them, and bring your portfolio back to its 00:35:22.760 --> 00:35:25.219 target allocation. And the related issue is the 00:35:25.219 --> 00:35:28.280 instability of the core premise itself. Changing 00:35:28.280 --> 00:35:30.699 risk tolerance. Your risk tolerance is not a 00:35:30.699 --> 00:35:32.599 fixed number you write down on a form. It's an 00:35:32.599 --> 00:35:34.880 emotional state. When an investor first signs 00:35:34.880 --> 00:35:37.360 up for an AA plan, they might agree to a 70 -30 00:35:37.360 --> 00:35:39.659 split. Sounds about right. But after five years 00:35:39.659 --> 00:35:42.199 of 15 % annual returns, they start to think, 00:35:42.280 --> 00:35:44.840 you know what? I can handle 90 % stocks. I'm 00:35:44.840 --> 00:35:47.059 invincible. And the opposite happens in a crash. 00:35:47.219 --> 00:35:49.619 The exact opposite. If they experience that 2000 00:35:49.619 --> 00:35:51.940 -2002 bear market and they see that negative 00:35:51.940 --> 00:35:54.639 34 % loss, they immediately want to shift to 00:35:54.639 --> 00:35:57.000 a 20 -80 portfolio and never own a stock again. 00:35:57.309 --> 00:35:59.690 so the lesson is that your risk tolerance is 00:35:59.690 --> 00:36:02.570 not knowable ahead of time it's not it is only 00:36:02.570 --> 00:36:05.750 tested and potentially changed by real world 00:36:05.750 --> 00:36:08.489 market experience and that change in tolerance 00:36:08.489 --> 00:36:11.809 leads directly to violating the aa policy usually 00:36:11.809 --> 00:36:14.349 at the worst possible time buying high and selling 00:36:14.349 --> 00:36:16.730 low it's often the direct result of an emotional 00:36:16.730 --> 00:36:19.030 change in your perceived risk tolerance okay 00:36:19.030 --> 00:36:21.269 next problem let's look inside the portfolio 00:36:21.269 --> 00:36:24.860 itself security selection mismatch right Even 00:36:24.860 --> 00:36:27.699 if you stick to a perfect 60 percent equity policy 00:36:27.699 --> 00:36:30.760 on paper, if you use that 60 percent to buy a 00:36:30.760 --> 00:36:33.699 very concentrated selection of, say, four highly 00:36:33.699 --> 00:36:36.500 speculative small cap growth stocks. You've subtly 00:36:36.500 --> 00:36:38.940 subverted your own plan. You have. Your portfolio 00:36:38.940 --> 00:36:41.400 will now behave far more volatile than the broad 00:36:41.400 --> 00:36:44.380 60 percent U .S. large cap equity category that 00:36:44.380 --> 00:36:47.420 your AA plan originally assumed. The policy requires 00:36:47.420 --> 00:36:49.880 broad diversification within each asset class 00:36:49.880 --> 00:36:52.380 to make sure the risk profile matches the assumption. 00:36:52.679 --> 00:36:54.380 Then there's the friction between. our lives 00:36:54.380 --> 00:36:57.500 and our plans. Time horizon mismatch. The great 00:36:57.500 --> 00:37:00.500 strategic benefit of asset allocation is realized 00:37:00.500 --> 00:37:03.139 over 20 or 30 years. That's the whole point. 00:37:03.579 --> 00:37:05.980 However, if an investor suddenly needs a big 00:37:05.980 --> 00:37:08.559 chunk of that money in two years, maybe for house 00:37:08.559 --> 00:37:11.500 down payment or a child's tuition, they now face 00:37:11.500 --> 00:37:14.079 a time horizon mismatch. A short -term correction 00:37:14.079 --> 00:37:16.739 could be a disaster. A short -term correction, 00:37:16.840 --> 00:37:19.179 which a long -term plan is designed to just... 00:37:19.449 --> 00:37:22.789 ride out, could force that investor to liquidate 00:37:22.789 --> 00:37:25.829 assets at a big loss, completely destroying the 00:37:25.829 --> 00:37:27.610 long -term premise of the plan. Which is why 00:37:27.610 --> 00:37:29.449 short -term money needs to be in safe assets. 00:37:29.670 --> 00:37:32.030 Capital required in the short -term must be allocated 00:37:32.030 --> 00:37:34.730 to cash and short -term fixed income, regardless 00:37:34.730 --> 00:37:37.369 of what your overall long -term ABA policy is. 00:37:37.630 --> 00:37:40.820 Okay, moving to structural issues. Tax and regulatory 00:37:40.820 --> 00:37:44.119 complexity. A simple 60 -40 mix becomes infinitely 00:37:44.119 --> 00:37:46.079 more complex when you start thinking about tax 00:37:46.079 --> 00:37:48.800 efficiency. You've got real estate, foreign bonds, 00:37:49.099 --> 00:37:51.380 assets held in tax -advantaged retirement accounts 00:37:51.380 --> 00:37:54.000 versus your regular taxable brokerage account. 00:37:54.219 --> 00:37:56.380 And each category is treated differently by the 00:37:56.380 --> 00:37:59.460 Pax Code. Completely differently. And optimizing 00:37:59.460 --> 00:38:02.139 your AA for tax efficiency can be incredibly 00:38:02.139 --> 00:38:04.860 challenging. Sometimes investors will compromise 00:38:04.860 --> 00:38:08.139 the entire structure just to achieve tax simplification, 00:38:08.380 --> 00:38:11.340 which is itself a structural failure. And linking 00:38:11.340 --> 00:38:13.840 back to Bogle's findings, the inevitable drag 00:38:13.840 --> 00:38:17.539 of cost and fees. Frequent rebalancing is mandatory. 00:38:18.079 --> 00:38:20.360 You have to do it to maintain the integrity of 00:38:20.360 --> 00:38:23.239 the AA structure. If your stocks run up, you 00:38:23.239 --> 00:38:25.199 have to sell them to buy bonds to get back to 00:38:25.199 --> 00:38:27.239 your target. And all that trading costs money. 00:38:27.739 --> 00:38:29.719 That act of trading, especially if you're doing 00:38:29.719 --> 00:38:32.460 it with high -fee mutual funds or brokers, generates 00:38:32.460 --> 00:38:34.980 substantial transaction costs and management 00:38:34.980 --> 00:38:38.260 fees. And those frictional costs directly erode 00:38:38.260 --> 00:38:41.099 your returns over time. It just shows why complexity 00:38:41.099 --> 00:38:43.239 and high costs are the enemies of a successful 00:38:43.239 --> 00:38:46.159 long -term plan. And finally, the allure of the 00:38:46.159 --> 00:38:48.920 quick win, the siren song of the market, court 00:38:48.920 --> 00:38:51.559 timing. This is the failure of the tactical approach 00:38:51.559 --> 00:38:54.460 in the hands of most investors. Accurately predicting 00:38:54.460 --> 00:38:56.739 the optimal times to move in or out of specific 00:38:56.739 --> 00:38:59.340 asset classes is one of the most difficult things 00:38:59.340 --> 00:39:01.619 to do consistently in finance. You have to be 00:39:01.619 --> 00:39:04.679 right twice. You have to be right twice. If you 00:39:04.679 --> 00:39:07.059 try to switch from defensive sectors to cyclical 00:39:07.059 --> 00:39:09.420 sectors because you anticipate a boom and you're 00:39:09.420 --> 00:39:12.059 six months too early, you end up sitting in highly 00:39:12.059 --> 00:39:15.159 volatile, poorly performing assets, racking up 00:39:15.159 --> 00:39:18.119 costs and sacrificing the compounding of your 00:39:18.119 --> 00:39:21.019 strategic core. Poor timing adversely affects 00:39:21.019 --> 00:39:24.000 returns far more than almost any other non -behavioral 00:39:24.000 --> 00:39:27.380 factor. So we have completed a pretty comprehensive 00:39:27.380 --> 00:39:29.559 deep dive today. We've moved all the way from 00:39:29.559 --> 00:39:32.099 the foundational theory of diversification to 00:39:32.099 --> 00:39:35.599 the painful reality of human implementation. 00:39:35.900 --> 00:39:38.079 And to synthesize it all, asset allocation is 00:39:38.079 --> 00:39:40.460 your portfolio's structural blueprint. It's fundamentally 00:39:40.460 --> 00:39:42.900 defined by your goals, your time horizon, and 00:39:42.900 --> 00:39:45.500 most importantly, your proven battle -tested 00:39:45.500 --> 00:39:48.119 risk tolerance. We explored the four main strategies, 00:39:48.320 --> 00:39:50.199 but the key takeaway has to be the supremacy 00:39:50.199 --> 00:39:52.900 of that strategic approach as the stable core 00:39:52.900 --> 00:39:55.550 of any plan. And we did it. We finally resolved 00:39:55.550 --> 00:39:57.710 the great academic debate. The crucial lesson 00:39:57.710 --> 00:40:00.289 from that whole BHB study is that AA governs 00:40:00.289 --> 00:40:02.570 the volatility and the level of returns. It provides 00:40:02.570 --> 00:40:04.909 the necessary risk containment. Get the allocation 00:40:04.909 --> 00:40:07.409 right, and you define a risk profile that you 00:40:07.409 --> 00:40:09.690 can actually live with. And that allows you to 00:40:09.690 --> 00:40:11.829 endure the inevitable market downturns without 00:40:11.829 --> 00:40:15.130 panicking. But defining that structure... It 00:40:15.130 --> 00:40:17.090 requires the utmost behavioral discipline to 00:40:17.090 --> 00:40:19.250 actually stick to it, to ignore all the market 00:40:19.250 --> 00:40:22.389 noise and to resist that primal instinct to chase 00:40:22.389 --> 00:40:24.929 performance or to flee from fear. Which brings 00:40:24.929 --> 00:40:27.190 us right back to that ultimate passive benchmark, 00:40:27.449 --> 00:40:30.369 the global market portfolio. We noted that this 00:40:30.369 --> 00:40:32.769 globally diversified average, the portfolio of 00:40:32.769 --> 00:40:35.989 the average world investor, realized a very respectable 00:40:35.989 --> 00:40:40.190 compounded real return of 4 .45 percent per year. 00:40:40.750 --> 00:40:43.030 over almost six decades. And it provided that 00:40:43.030 --> 00:40:46.210 resilience across massive inflationary and disinflationary 00:40:46.210 --> 00:40:48.789 economic shifts. It did. So here is our final 00:40:48.789 --> 00:40:50.849 provocative thought for you to consider. Given 00:40:50.849 --> 00:40:52.789 that the global market portfolio represents the 00:40:52.789 --> 00:40:55.070 optimal benchmark for the average globally diversified 00:40:55.070 --> 00:40:58.090 investor and recognizing the nine powerful human 00:40:58.090 --> 00:41:00.329 and practical obstacles that routinely cause 00:41:00.329 --> 00:41:03.769 active or tactical AA to fail, how should you 00:41:03.769 --> 00:41:06.449 use this market -wide average? Should you perhaps 00:41:06.449 --> 00:41:09.960 adopt the GMP's structure? the composition of 00:41:09.960 --> 00:41:12.940 all the world's assets as the immutable, passive, 00:41:13.039 --> 00:41:15.760 low -cost core of your personal strategic allocation, 00:41:16.059 --> 00:41:18.980 and only deviate from it minimally to suit your 00:41:18.980 --> 00:41:22.019 specific personal liquidity needs. By using the 00:41:22.019 --> 00:41:24.619 GMP as the baseline, you essentially neutralize 00:41:24.619 --> 00:41:26.980 all those difficult emotional decisions of security 00:41:26.980 --> 00:41:29.360 selection and market timing. And you allow the 00:41:29.360 --> 00:41:31.500 natural resilience of global diversification 00:41:31.500 --> 00:41:34.340 to do its work while maximizing your own behavioral 00:41:34.340 --> 00:41:36.900 discipline over a decades -long time frame. It's 00:41:36.900 --> 00:41:39.050 food for thought. for your own blueprint. That's 00:41:39.050 --> 00:41:40.590 a wrap on the deep dive. We'll talk to you next 00:41:40.590 --> 00:41:40.769 time.