“Everything should be made as simple as possible, but no simpler” – Attributed to Albert Einstein
I love this quote. And, I love Albert Einstein. He was able to fundamentally shift the way we understand the universe and his big breakthroughs often started as thought exercises. The germ of his Theory of Relativity was planted when he was 16, with him imagining what the universe might look like if he could ride a beam of light. (more on that here)
March 14, 2019 would have been Einstein’s 140th birthday. To celebrate, this post is a thought exercise to help you decide how complex your investment portfolio should be.
The number of investment products available to investors seems almost infinite. Savings accounts, money market accounts, precious metals, individual stocks & bonds, mutual funds, exchange traded funds, fixed and variable life insurance products, options, and now cryptocurrency… the list goes on and on. Some of the products are straight-forward and fairly simple to understand. Other products are incredibly complex with so many moving parts that it is difficult for even the most financially-savvy investor to keep track.
So, how do you choose the right investment (or handful of investments) for your situation? If you imagine all of the investment options laid out in order from the simplest to the most complex, a spectrum would emerge, with incredibly simple investments on the left, and incredibly complex products on the right.
The way I like to use this spectrum is to start with a very simple investment, like a savings account, which would land pretty close to the left end of the spectrum. I then try to decide whether to use that investment or look for one slightly more complex. But, in order for it to be worth the extra complexity, the new investment has to offer something of value to compensate me for taking it on, otherwise I’ll just stick with the savings account.
For example, if I am deciding between a savings account and a money market account, it may be the case that the rules for withdrawing my money are more complicated for the money market account. In exchange for that extra complexity, I would expect to be paid a higher yield. And, in order to receive that higher yield, I have to play by the rules of that investment… otherwise, fees eat up my extra gains.
If I continue down the path of adding complexity, at some point I will encounter an investment portfolio that is so complex that I’m am not able to take full advantage of its benefits for one reason or another:
- Maybe the investment has so many rules that I get confused and don’t use them to my advantage.
- Or, the rules don’t benefit my personal financial situation.
- Or, (I find this to be the most common issue) the investment technically has all of the benefits the investor is looking for but it is so complex that the investor does not make the time to learn all of the details.
So, an investment may technically have all of the bells and whistles that would conceivably make a good investment, but the investor does not (or cannot) take advantage of those benefits
Investment Complexity Test
When trying to decide how to invest your hard-earned money, keep the goal in mind: you want to get paid for having money. So, you need a portfolio that is complex enough to provide you with returns. But, not so complex that you are unable to take advantage of it.
The test I like to use for determining my ideal portfolio complexity has three parts: Division of Labor, Execution Errors, and Cost.
Division of Labor
One way to add a bit of complexity to a portfolio is to divide it into sections and assign a job to each section. In essence, creating a division of labor for your money as you put it to work. Most portfolios have at least three sections: stability, income, and growth.
For many investments there is a trade-off between stability and returns. For example, savings accounts are very stable with low returns, and small-cap stocks are much less stable with the potential for very high returns.
To balance this trade-off, you could divide your money. A portion would be tasked with providing stability, and another potion would be responsible for producing higher returns.
I know that allocating your assets is not a new or revolutionary idea for most investors. But what I’m suggesting here is to make sure that when you are building your asset allocation, make sure that the division has the right level of complexity for what you’re trying to accomplish.
When I was a financial advisor, I would meet with prospective clients who would show me the portfolios they had built with their previous advisor. Often, I would see portfolios with $10,000-$20,000 with as many as 15 or 20 different investments including some individual stocks and a variety of mutual funds.
I would ask them the purpose of each investment in their portfolio, and the answer was usually something like, “my advisor said it was a good bet.”
This is investing. Not gambling. I don’t make bets.
The real answer was that there were multiple holdings inside the portfolio that had the exact same goal. So, there was complexity added that did not add extra value.
Instead, I like to build my portfolio with exactly five (or fewer) holdings. I describe them in more detail in my book, but they are all broken into large-cap stock, mid-cap stock, international stock, high-yield bonds, and investment-grade corporate bonds. Each investment has a very specific job to do, and no two investments are doing the same job.
By allocating the portfolio into too many small sections, the ability to effectively execute your strategy can get overly complicated.
For example, if you have 100 different holdings that you are managing then you would need a pretty sophisticated management system to make sure that each of the trades you are executing is moving your portfolio toward your goal and simultaneously ensuring that you are not throwing your portfolio out of balance every time you make a trade.
That’s why I like to build portfolios with five (or fewer) holdings.
I have found that I can fairly easily manage my portfolio that has exactly five holdings. I can monitor my performance, easily rebalance, and then go back to living my life. The portfolio is complex enough that I have portions that are stable, portions that provide income, and portions aimed at growth, but not so complex that I get lost in the details. Plus, by using mutual funds and exchange traded index funds, I can get exposure to pretty much any part of the market I want without having to pick individual stocks and be exposed to the whims of one single board of directors.
I like to think of investment cost in two ways: money and time.
When deciding how complex my portfolio should be, I recognize that there is often an increased financial cost for more complex portfolios. Actively managed mutual funds can add some complex management techniques and critical analysis to your portfolio, and that can cost you around 1% of the account value annually. In my book I explain why I think that extra cost is worth it for bond funds, but not for stocks.
The other cost that increases with complexity is time. If I had a portfolio with 100 moving parts and I wanted to make sure I was really managing it properly, I would basically have a full-time job. I would need to be constantly monitoring the performance of each piece and carefully executing trades. That may be fun for some, but it is not for me.
Instead, I allocate my portfolio into exactly five pieces. I rebalance once per calendar quarter, so I can quickly and easily make my calculations and my trades in a matter of minutes. Then, I’m back to living my life.
What it all means
I know this thought exercise is not as ground-breaking as anything Einstein ever did. But, I hope it helps. My goal is to have a portfolio that can achieve my goals as simply as possible. No more, no less.
The right portfolio for you will have an allocation that you can manage, with costs under control, and little chance of execution errors.
You will know you have found the right portfolio for you when it all just clicks. When you know exactly what your strategy is and you know exactly how and when to execute it.
It is incredibly liberating.
No more guessing about which stocks to buy or when to sell. No more wondering if you’re doing the right thing every time you make a trade.
I know I haven’t given you enough to build the perfect portfolio allocation in this one blog post. That wasn’t my goal for today.
What I hope I have given you is a way to think about investing to help you eliminate portfolios that are too complex to really manage as well as portfolios that are too simple to be able to achieve your goals.
I hope this has been helpful! Comment below with your thoughts and questions.
And, be sure to check out my book, Practically Independent: Practical Advice to Become Financially Independent. It has an entire section on investing and includes model portfolios and outlines my strategy to stop gambling and start getting paid for having money.
Available in paperback and e-book on Amazon.com.