Are You Taking Enough Aspirational Risk?
25:45 Share

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein, and today is episode 496. It's titled, Are You Taking Enough Aspirational Risk?

In 1952, Harry Markowitz of the Rand Corporation published a paper titled Portfolio Selection in the Journal of Finance. The paper introduced what came to be known as modern portfolio theory. Markowitz eventually garnered a Nobel Prize for his work on portfolio construction. Modern portfolio theory, or MPT, is a method for constructing optimally diversified portfolios that maximize

maximize the expected return for a given level of risk. Risk in MPT is measured by volatility, specifically standard deviation. How much does a given asset or portfolio deviate from the expected return? In order to construct a portfolio using MPT, and I did this for years as an institutional investment advisor, we

We need an expected return for each asset class. We need an expected volatility as measured by standard deviation. And we need a level of correlation between the asset types. To what extent do the different asset classes' returns track each other? Do they go up and down by the same amount or do they move in opposite directions?

The optimal portfolio derived from MPT will fall along a risk-return line, which is known as the efficient frontier. What the model does is it will generate a series of portfolios with certain weights in each of the different asset classes. It could be large-cap stocks, small-cap stocks, bonds.

Any asset class can be included as long as we come up with an expect return, a volatility, and a correlation. And so the model generates these portfolios, and the optimal ones lie along this risk-return line called the efficient frontier. As an institutional advisor, I would run these studies, I would meet with

an endowment investment committee. We would talk about the different portfolio options and look at what the weights were in the different asset classes. Here's what I found. Clients didn't want an efficiently optimal portfolio. They wanted a portfolio that was palatable.

They didn't necessarily want what the model spit out. They might not want 30% in small cap stocks, if that's what the model said, which is why we back in the office, we would come up with constraints for different asset types. No more than 15% in small cap stocks, for example.

We would essentially build a portfolio using those constraints, using the assumptions in order to come up with portfolio options that we knew the committee would find acceptable, that were similar to what their peer universities were doing. It was sort of like providing an optimal diet for clients using only the food groups and the amounts that they're willing to eat.

What I learned is that, yeah, we can use MPT to build diversified portfolios, but there's a human element to portfolio construction. It's super difficult just to optimize it because of this human element.

That same year, 1952, when Markowitz released his paper on portfolio construction, there was another paper released by British economist Andrew Donald Roy, who went by A.D. Roy. This paper was titled Safety First and the Holding of Assets. It was published by the Econometric Society.

Roy's paper also emphasized the importance of diversification, but it also brought up what could be considered a flaw in modern portfolio theory. With its focus on expected returns and probabilities, optimization, average expected returns, here's what Roy wrote. The ordinary man has to consider the possible outcomes of a given course of action on one occasion only.

And the average or expected outcome, if this conduct were repeated a large number of times under similar conditions, is irrelevant.

What he's getting at is, as individuals, we only get one shot. We're not a Monte Carlo simulation. Modern portfolio theory assumes the average expected return. You can see ranges of expected returns. But as we go through life, the sequence of returns we get in the stock market, how much we save, is there a major market crash right before retirement? That matters and impacts...

are returns. Benoit Mandelbrot, in his book, Misbehavior of Markets, which points out some of the issues in modern portfolio theory, he wrote, what matters is the particular, not the average. And Mandelbrot pointed out that extreme events occur much more frequently than what is assumed with modern portfolio theory.

A.D. Roy in his paper talked about a lot of the assumptions that economists or financial technicians use, academics assume that things occur outside of time or that everything is, for lack of a better word, hunky-dory.

He says a better assumption would be assumed that we're on a journey in choppy waters in the ocean or in the jungle. And what matters is what's around the corner, a hurricane coming up or a ferocious tiger. Survival is incredibly important in the real world, not just back running modern portfolio theory, Monte Carlo simulations, coming up with assumptions. And it's that reality.

run-in of the theory with how we as humans live and think and make decisions where it can fall apart. And in this episode, we're going to look at a particular way it falls apart when it comes to aspirations that we have. Before we continue, let me pause and share some words from one of this week's sponsors, NetSuite. What does the future hold for your business? If you ask nine experts, you'll get 10 answers. But

Bull market, bear market, interest rates will rise or fall, inflation up or down. Nobody knows. No one has a crystal ball. But over 38,000 businesses have future-proofed their businesses with NetSuite by Oracle, the number one cloud ERP, bringing accounting, financial management, inventory, HR into one fluid platform.

With one unified business management suite, there's one source of truth, giving you the visibility and control you need to make quick decisions. With real-time insights and forecasting, you're peering into the future with actionable data.

When you're closing the books in days, not weeks, you're spending less time looking backwards and more time on what's next. I know in our business, as it grows, we'd love to have something like NetSuite by Oracle. Now, speaking of opportunity, you can download the CFO's Guide to AI and Machine Learning at netsuite.com slash David.

The guide is free to you at netsuite.com slash david. netsuite.com slash david.

We looked at this idea of we only get one shot earlier this year in episode 460. It's a theme we've covered numerous times. That episode was, should we be 100% invested in stocks? They went through the analysis of different portfolios and came to the conclusion, the paper that we were analyzing, that yeah, you are better most of the time being 100% in stocks.

But what we don't know is what an investor that experiences catastrophic losses, how they will react. What will they do? I mentioned that I know investors that never return to the stock market after the brutal losses of the great financial crisis. So we get one shot in terms of our investment decisions as we pass through time. And we don't know how we'll react.

I thought about this a lot as I recently found a paper by Ashvin Chhabra. It's an old paper, came out almost 20 years ago in the journal Portfolio Management.

Chabra, back then, was a financial advisor. I guess he still is. He's president and chief investment officer of Euclidean Capital. Euclidean Capital is the family office of James Simon, who is a hedge fund manager and founder of Renaissance Technology. Chabra wrote a book based on the work in this paper. The book's called The Aspirational Investor. And in that paper, he points out that the vast majority of investors aren't well diversified. The

They don't have optimal portfolios as described by modern portfolio theory. Furthermore, a meaningful percentage of affluent clients got wealthy by not following the principles of modern portfolio theory. They were undiversified. And it isn't just the wealthy. He gives some examples. Investors who had...

a mortgage, they were highly leveraged. They only put down 10% to 20%, sometimes less, to purchase a home. And because of that leverage using the mortgage, the homes appreciated in value and it quadrupled. And in many cases, more than quadrupled the value of their down payment. They took a big bet on

a house, and they won as the housing market went up. Others did that, and they lost their down payment, and they ended up walking away. But that was not a diversified bet when we put the majority of our net worth in a home and then borrow against it in order to lever up our investment. Now, we don't typically think of buying a home like that. Another undiversified choice is

individuals that work for a company and they get stock or stock options and the company does incredibly well and it significantly increases their wealth because of one company where they worked. We have a member of Money for the Rest of Us Plus that we've done some plus episodes on, premium podcast episodes as we talked about his situation and that's where it was. He got incredibly wealthy because the company he happened to work for did incredibly well.

We have individuals that are involved in a startup, start their own business, a private business, and keep reinvesting in it. And that's the majority of their net worth. It's a situation that I was in. It's how I built the wealth that we have. I worked for this investment advisor. We sold the firm in the early 2000s, and we bought it back three years later in a very large leverage buyout. We bought it.

We borrowed multiples of our net worth, assigned personal guarantees, put our homes on the line, and it worked out. And so then I'm in my early 40s, and I can see that this is the value of this huge bet I took. And I remember sitting back and thinking, well, if it just implodes, I have this in my 401k, and if I save this much of my...

Sorry, I'm going to be okay, but I also have this equity value in the business. I could cash out on that now and start over and do other things, which is what I ultimately did to realize that value to have an exit strategy. But it wasn't diversified. No.

Now, one of the things that Chabra points out is maybe this is an example of survivorship bias, a topic we talked about in episode 421. And I recently did a post on LinkedIn on survivorship bias, which is a really cool graphic that Camden put together. If you're not following me on LinkedIn, reach out and you can follow the post that we do. We do a couple a week. But survivorship bias is focusing only on the survivors, not the whole picture.

Maybe we're only focused on the successful examples of startups or individuals that kept the majority of their net worth with the company they're working for and it worked out. Or those whose house skyrocketed in value and they were heavily, heavily leveraged. What about the examples that didn't work out?

Now, Chabra believes, just given the sheer number of affluent that have increased their net worth, that it isn't just survivorship bias. There's actually something there not being diversified. Taking a big bet has worked out for many people. One of the things he does in the paper, and I looked at some updated statistics, is look at the wealth distribution in the U.S. and the census bureau.

Bureau does an annual study of this. And if you look at the percentile breakdown, the 10th percentile, probably even up to the 15th percentile, they don't have any net worth. And the 25th percentile has around $27,000 in net worth. And Chabra points out that about a third of the U.S. population is only one

bad event away from bankruptcy. It could be a medical bankruptcy or they just don't have much net worth. And then as you go up, the percentile, the 50th percentile, so the median is

is about $192,000 in net worth. 75th percentile, $658,000. And then when you get to the 90th percentile, those 90 and above have net worths of at least $1.9 million. And the top 1%, about $13.7 million. And above that, the 0.1% would have multiples of millions more.

And his takeaway is the bottom percentiles are very much at risk of ruin. But in order to move up meaningfully with millions of net worth, most people won't get there unless they take some aspirational risk. They do something that has an extreme payoff to the upside that's positively skewed.

a topic we talked about earlier this year in episode 482. Something is positively skewed if there's an extreme positive payoff that brings up the average. Most of the time it doesn't work out, but there are those examples where it does. And that's attractive to us as humans and as investors because that can move the needle, could move us into a different level of wealth. We are attracted to that. At the same time, we also have a great fear of ruin.

We're not there in the middle just doing optimization. We're more like A.D. Royce says. We're fearful of being ruined. And that was the topic of episode 250. We're approaching episode 500 here in a few weeks. Episode 250 was investment rule number one, avoid ruin.

And it was focusing on not building optimal portfolios, but protecting against the downside so they were not destroyed by a catastrophic event. Now, I fall into the habit of probably focusing too much on avoiding ruin.

And ignoring the fact that we're conflicted, we also are attracted to positively skewed investments or situations that could benefit us and move the needle and move us into a higher level of wealth. And I need to be careful not to denigrate that. Before we continue, let me pause and share some words from this week's sponsors. Have you ever wondered how much of your personal data is out there on the internet for anyone to see?

More than you think. Your name, contact info, social security number, and home address. Even information about your family members. All being compiled by data brokers and sold online. That's why I use Delete.me. Delete.me is a subscription service that removes your personal info from hundreds of data brokers. Delete.me sends me regular personalized privacy reports. I just got one a couple weeks ago showing what info they found, where they found it, and what they removed. That's

That's because Delete.me isn't just a one-time service. Delete.me is always working for you. That's why I subscribe to it. I pay for this subscription because they are constantly monitoring and removing my personal information, information that we don't want on the internet.

To put it simply, Delete.me does all the hard work of wiping your and your family's personal information from data broker websites. Take control of your data and keep your private life private by signing up for Delete.me, now at a special discount for our listeners. Today, get 20% off your Delete.me plan when you go to joindeleteme.com slash david20 and use promo code david20 at checkout.

The only way to get 20% off is to go to joindeleteme.com slash david20 and enter code david20 at checkout. That's joindeleteme.com slash david20, code david20.

A few episodes ago, we looked at the five layers of investing. And I mentioned the pitch for those that are selling courses and trading academies for short-term trading, highly speculative investments that are positively skewed. Those are attractive because as humans, we like that opportunity. That's why lotteries exist.

Daniel Kahneman and Amos Tversky, two behavioral psychologists, economists, also won the Nobel Prize for their work. One of their books is Thinking Fast and Slow. They released a 1979 paper on prospect theory. Prospect theory describes how, as humans, we have this dual nature.

we require a higher expected return for more volatile assets because we have loss aversion.

We don't want to experience a loss. We hate that feeling. In fact, we fall into what is known as narrow framing. If we see a risky situation, if we're building out a portfolio, we'll focus just on the risk of that asset as opposed to what modern portfolio theory would say. Well, it's part of an overall portfolio is diversification. But

but we focus specifically on that risk and we have loss aversion related to that. And so if something's volatile, we want a higher expected return, unless that opportunity is positively skewed. We're willing to take a lower average expected return if there's extreme upside, maybe a low probability of that upside, but if the upside's extreme, we'll do that. Cryptocurrency is example of that. Cryptocurrency, Bitcoin's been positively skewed.

And others, even though the expected return might be lower. So in episode 42, where we talked about positive skewness, we hinted at this paper by Chabra, which I hadn't read at the time, about a barbell strategy.

We take actions to protect against the downside, loss aversion, being ruined, destroyed. That's one side of the barbell. But we can also speculate in areas that we could benefit from positive skewness. Perhaps we start a business on the side or we participate in cryptocurrency. Maybe we even trade options, but we don't do it at a level that will be ruined if it doesn't work out.

Chabra mentions a barbell strategy, but he puts even more of a framework about it. He outlines three portfolio objectives. The first is to protection from anxiety, poverty. What he refers to as protection from personal risk that will be ruined. Portfolio needs to do that. The second is the ability to maintain our standard of living and status in society. Keep up with our friends and family. And we do that by taking on market risk.

That's our diversified portfolio, primarily invested in investments with positive expected returns, cash flow generating investments, stocks primarily, but other asset classes. And it should be diversified. And we can use modern portfolio theory to do that. That's to maintain our standard of living. It's different from protecting against poverty. And some of the things we do to protect against poverty, and we'll give other examples of this, would be we buy insurance. Kind

catastrophic health insurance, life insurance to protect our loved ones, disability insurance in case we become disabled. So those are the first two, protection from poverty. Second is to maintain our standard of living. And then the third bucket would be aspirational risk, to provide an opportunity to increase our wealth substantially or to meet aspirational goals.

Those investments are different. So those are three portfolio objectives and three levels of risk, personal risk, market risk, aspirational risk. And we protect against the personal risk by we're protecting against the downside. We take on market risk so that we can build a portfolio, but we can handle the volatility because we are protected against ruin. But then we have the aspirational investments and risk to really move the needle.

to change our life, potentially.

What are some examples then? Well, in the personal risk bucket, we have low-risk investments. It could be cash, emergency savings, for example, short-term government bonds, treasury inflation protection securities. If one's retired, an immediate annuity falls in that personal risk bucket. An annuity where we are guaranteed income for life as part of a safety-first annuity

where we're covering our minimum living expenses to keep us out of poverty with guaranteed income sources or very low risk. We've discussed about a year ago building out a bond ladder made of treasury inflation protection securities. These are lower risk investments that protect us against catastrophic events and that would include health insurance, life insurance. It also includes our human capital.

Our ability to generate income, which is why a single individual in their 20s, they can take more market risk because they're still building up their portfolio because at the personal risk level, they certainly need health insurance, but they have a whole bunch of human capital, time to earn and build skills.

A personal residence, somewhere to live, could fall in the personal risk bucket. My friend Joshua Sheets did an episode a few weeks ago that I listened to where he talked about we should own clear and outright our personal residence. And he was specific not to say our home, just somewhere. Maybe you start with a tent or a camper, but somewhere that you're not left unhoused

If something catastrophic happens. Somewhere we can live if we lose our job, not lose our house. So that would fall in the personal risk bucket. Market risk includes conventional securities, stocks.

Non-investment grade bonds, convertible bonds, preferred stock, many of the asset classes that we talk about on Money for the Rest of Us, we have video lessons on in our premium membership community, Money for the Rest of Us Plus. These are traditional securities where

where we're trying to generate a real return net of inflation that compounds over time, that allows us to build out a retirement portfolio, and ultimately to take some of that market basket and move it into the personal basket to protect us from ruin. Maybe we buy an immediate annuity when we're retired.

or something that's incredibly safe, but we're taking on the market volatility, that market risk in order to diligently save over time to build out our net worth. We'll probably not be in a situation where that will grow to $10 million. If we're diligent, it potentially can get to $3 to $4 million. If we're making six figures and we're saving

15 to 20% of our income, but this is just to build out a portfolio that we can live on in retirement.

Then the third bucket then is the aspirational risk. This could be a concentrated stock position. Maybe you owned NVIDIA. You have some individual stock positions that do incredibly well. That's in the aspirational risk bucket. It could be a leveraged real estate transaction, a family-owned business, but something that isn't

isn't going to ruin you if it doesn't work out, and that you're still taking on market risk and saving on a regular basis to build out your retirement nest egg. But this is a third category. This is the aspirational category, that if it works out, it will move us to a different level of net worth. Finding the balance is a challenge.

But it's important to not get caught up and put everything in the aspirational risk bucket. I'm reading a book by Scott Galloway called The Algebra of Wealth. And he doesn't use these terms, but he basically said up until his mid-40s, he was all in in aspirational risk, doing numerous startups, knew everything was going to work out in his mind, but it didn't. And it wasn't until they had his first child in his early 40s and he realized he didn't have any wealth. And that's when he started

building out personal risk assets and more conservative market risk assets, and then complemented with his aspirational risk that he was taking in his profession. We need all three. But as humans, we're wired for positively skewed investments and opportunities. We're aspirational. And that's okay. That's great. But we can't go all in with aspirational risk.

But we should probably take some. It's what makes life interesting. It allows us to follow maybe a passion project or something where there's huge upside. Not the likely outcome, but it's possible. But make sure we've covered the personal risk to avoid ruin. We're saving for more traditional investments, a nest egg, and then we can have this third category and enjoy it. That's our discussion on are you taking enough aspirational risk? Thanks for listening.

You may be missing some of the best money for the rest of us content. Our weekly Insider's Guide email newsletter goes beyond what we cover in our podcast episodes and helps elevate your investment journey with information that works best in written and visual formats. With the Insider's Guide, you can discover investing and economic insight provided only to our newsletter subscribers. Unlock greater investing confidence with high value snippets from our premium products. Plus,

plus membership and asset cap. Further connect with the Money for the Rest of Us team and community. And when you sign up, we'll also send you our exclusive investing checklist to help you invest with more confidence right away. You'll also get our introductory email series on eight essential investment principles that if followed can make you a better investor. We'll also share our recommendations for podcast episodes, articles, and books.

The Insider's Guide is the best next step to get the most out of your investment journey. If you're not on the list, go to moneyfortherestofus.com and subscribe right there on the homepage. Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.