Our Podcast Interview with “Stacking Benjamins”
On the heels of our publishing Adaptive Asset Allocation, over the past couple weeks, we were invited to join a number of excellent financial podcasts. We love these types of opportunities, and they differ from traditional media interviews in that we actually have the time for a meaningful discussion with the hosts and their audiences.
What follows is a lightly edited transcript of the interview, with links to the resources referenced in the interview. Enjoy!
Joe: Asset allocation, what a topic…asset allocation sounds so boring! Just those words when you put them together. But this is the sexiness people are looking for with their finance, right? This is the stuff that “Oh, we’re going to talk stocks and bonds now. Oh, yeah!” That is the stuff people love to talk about.
OG: And [asset allocation] is ultimately so boring, right? Stocks and bonds are what people want to talk about. But that’s the thing that you should spend the least amount of time on.
Joe: Right! Well, guess what? You and I are going to spend much time on it today because we’ve got a guest coming down to the basement: Michael Philbrick who is President of ReSolve Asset Management in Toronto, Canada.
Michael: Thanks for having me here.
Joe: Yes, and you have a #1 Hot New Release on Amazon. How does that feel?
Michael: That feels pretty neat. I mean there’s a lot of work that goes into it and I can’t thank the other people that were involved enough. It’s pretty fun when you get some experience under your belt and you share with the world and it’s met with some enthusiasm. That’s pretty neat.
Joe: Well, let’s dive in a little bit Mike because you guys talk about adaptive asset allocation. I think the first thing we need to do is just define those terms. First of all, asset allocation is one of these terms that guys like you and I throw around all the time. But what does it really mean?
Michael: Well, that’s just the decision of the amount of money we would put into major asset classes. Stocks are an asset class. Bonds are an asset class. Real estate, commodities, these are all asset classes. Asset allocation is the decision on how much of your money you want in each one of those assets classes.
Joe: And why adaptive?
Michael: [Let’s step back first and define the asset allocation continuum.] There is strategic asset allocation. Then you get into tactical asset allocation and then you get into adaptive. So it’s the level at which you want to make changes to those allocations that you’ve made.
Strategic asset allocation basically means that you’re going to do it once and forget about it.
Michael: And then you get to more and more responsive until you’re – I guess adaptive we would consider the most aggressive when it comes to changing your allocation.
Joe: So you guys change your asset allocation fairly often.
Michael: We do. We feel that the world requires it, right? The world changes constantly and we think that your portfolio should account for that. If there’s a train coming, don’t stand on the tracks. I don’t care if you step two steps to the left or two steps to the right. Don’t stay in the tracks.
Joe: Because long term, that track is mostly empty.
Michael: Right! When the train is coming, just left and right, not forward or backward. Left or right, two steps. You don’t have to absorb all of the ferocity of a bear market if you don’t want to. There are ways to adjust and adapt. We would argue that you should take advantage of that.
[Editorial Note: This metaphor had the best intentions, but it didn’t exactly “land.” The proper comparison would be: strategic asset allocation is like standing on the train tracks and refusing to move. 95% of the time, you’re going to be perfectly fine, but just as periodic market crashes are an accepted part of buy-and-hold, so is getting hit by the periodic train an accepted part of standing on the tracks. Just take a couple steps to the side when the situation calls for it!]
Joe: Let’s talk about the story you open the book with. You guys had two clients with your firm, both senior executives and they had lots in common. One worked for a pharmaceutical firm, the other for an energy company. They both seem to know a lot about money. Can you tell that story?
Michael: Sure. So, I don’t know if you’re familiar with Nassim Taleb’s turkey parable, but it goes like this: One day a turkey hatches and sees the farmer and the farmer makes sure he’s fed and makes sure there’s a fence is up so the fox can’t get him.
The turkey continues to bond with the farmer over time and continues to have the farmer reward him and we get close to October and into November and the farmer actually starts to even feed the turkey more than he wants to eat. He makes sure the foxes are shooed away from the turkey house and then all of a sudden it’s Thanksgiving and the turkey ends up on the table, right?
The lesson is: How can a person who owns a stock that has done exceedingly well know when that stock may or may not one day take their head off?
That is really what we’re faced with is this uncertainty and in life, as you go through life, every opportunity or everything that happens to you is an opportunity to either manage overconfidence or build resilience.
In the book, one guy is managing overconfidence and the other guy is building resilience. But if you happen to be an Enron or WorldCom or in Canada, Nortel employee, things went very wrong. But if you happen to be an employee of Google or Netflix or Facebook, I mean why would you diversify?
Joe: Well that is the story – I mean one of these guys worked for Enron and looked you guys in the eye and said, “No, I’m going to keep all my money in a single stock,” and like the turkey, he ended up with his – he ended up on the table.
Michael: How could he know? He has been treated so well and that is really – we bring client attention to it. We call it either “round tripping” or the “popcorn event.” I can’t tell you how many times I’ve seen clients and we have to make sure we tell them the story over and over again where they’re sitting on a very large sum of money and we say diversify and they say, “Are you nuts?” because they’re the turkey. They’ve been just fed so well. They say “How could my firm betray me?”
Joe: Well, and I also think that when it comes to overconfidence Mike, we’ve got this idea that because it’s done well in the past, that means it’s going to do well tomorrow, right? It means that things are going to continue along the way that they are, which you guys have shown is not always the case.
Michael: That’s exactly right. There’s a classic human frailty. We project the current set of circumstances into the future. It’s what we do. The weather is nice. It will stay nice forever. If it’s cloudy, we will never see the sun again.
Joe: When people diversify, the second problem that they have is that they diversify based on popular benchmarks, right? The S&P 500 is a popular benchmark and I know being a recovering financial adviser that clients would come in and they would look at me and they would say, “OK. So how are we doing versus the S&P 500?” You guys say, “Who cares?”
Michael: Exactly. I will tell you that the entire way people select benchmarks is just so strange. Really, the number one criteria is, “Are you going to reach your financial goals?” And then, let’s do that as smoothly as we can.
Then you look at the S&P 500. As a great example, compare March 2007 versus March 2009. In March ’07 is when clients were crawling up the walls saying, “Why aren’t you keeping up with the benchmark?”
The funny thing about it is that if you’re in one of those passive portfolios where you’re looking at the S&P 500 as your benchmark, then when your manager puts up a 48 percent loss and the S&P loses 50 percent, you should be patting that manager on the back. An exceptional job!
Michael: You outperformed by two percent. If you complain, you’re out of your mind!
Joe: Yeah. How many people have you and I met that complain about that? I mean I’ve met a ton of people. They’re like, “But I didn’t want to be down 24 percent when the market was down 35 percent.” Well, OK then.
So instead, when you talk about adaptive asset allocation then Mike, what do we do? We diversify and asset allocate based on the goal. We create our own benchmark like a blended benchmark that we’re looking for. What type of benchmark should we actually shoot for?
Michael: For us, if you say, “What is the benchmark for adaptive asset allocation?” that’s I think a fairly easy question to answer. It’s the global market portfolio.
Michael: But I think the context of your question was, “What’s the benchmark for the person?” and the benchmark for them is achieving their financial goals. It really is minimizing the probability that they won’t achieve their financial goals. We talk about that as being the iron law of financial planning for us, for individuals is that everything should be to minimize the chances that you don’t achieve your financial goals.
Now once you reorient yourself to that goal, and then you say, “Well, OK, how much S&P should I own?” well, you got to work it in there. But that S&P can have a 50 percent loss along the way. And how would that impact your financial goals if you’re nearing or in retirement? Because these near-retirement years are very, very dangerous periods and they will have long term impacts to your financial plan.
Joe: It isn’t just getting the number. It’s when you post the number.
Michael: Oh, absolutely. That’s another thing we go into in the book: Whether you’re lucky or you’re unlucky. Imagine a client that retired at 1982 right before a 20-year bull run in stocks, like 20 percent a year relentlessly, I mean that guy retires perfectly OK [if he’s invested heavily in the S&P 500]. Then imagine that someone else retired in 1966. That poor guy got 5 percent total returns with a 50 percent loss and two 30 percent losses in the middle. He did not make it.
Joe: That’s horrible. Yeah. It is so frustrating because people always ask us “What do we do in the future?” Who knows? Which I guess brings up my next question which is: When it comes to volatility, how do you guys propose that people get rid of volatility in the portfolio?
Michael: First of all, diversification. It’s the explicit recognition that we don’t know the future. So you’ve got to consider all your options. We often see stocks and bonds and portfolios. But what about commodities, real estate? What about corporate bonds? And then how much?
We would argue that you should keep the risk consistent. So you should target volatility. So we target volatility at the 8 percent level.
Joe: Oh! That’s interesting. So instead of just targeting returns, you’re saying I’m going to expect X amount of volatility in my portfolio.
Michael: Bang on. That’s the thing. You can target returns. Then you’re going to let volatility happen.
Michael: Or you can target volatility and let returns happen. So if we target returns, most people are used to that. I want equity returns. I want 10 percent per year from a portfolio that’s 100 percent stocks. Great. That means you have to let risk happen. So when that train is coming down the tracks at you and you’re on the tracks, don’t move.
For us, we’re just a little bit more – listen, let’s target risk and let’s let returns happen. Let’s make sure the experience doesn’t scare us, thereby enhancing our opportunity to stick with the plan because we all know that people make those poor decisions, especially under duress. We’ve got these behavioral issues that layer the complexity on top. So we want you to diversify.
Broaden your horizons. Really look at every opportunity. If Japanese stocks are doing well, and they’re doing better than US stocks, do you care that I’m going to put you in Japanese stocks? No, you’re going to say, “Please, by all means.”
Joe: Yeah, more of that.
Michael: Yeah, exactly. If an asset actually diversifies the portfolio and reduces the risk while we maintain a level of return, well, by all means give me more of that. Then finally this whole targeting of risk. It’s not as hard as you think. You really just have to look at what’s going on and adapt.
Imagine a thermostat on the wall. I’m looking at the thermostat on the wall down here in the basement, and that thermostat does not have to predict the temperature in here to keep us comfortable.
Joe: And rarely does it by the way.
Michael: Right? All it does is kind of look – you know, feels around the room and says “It’s 70 degrees at the moment. You guys set it at 72. Let’s kick the heat on for a little bit,” and then it turns itself off. It observes and adapts. It doesn’t predict and it keeps us comfortable. With your portfolio, you can do the same thing; observe the current conditions and then adapt the portfolio based on that.
Joe: I feel like you’re the pilot that’s telling the passenger how comfortable they’re going to be along the ride. So like “Listen, I don’t know what’s going to happen in terms of wind flows, but in terms of bumpiness, I can tell you this is the level of bumpy we’re going to have.”
Michael: You got that right and your pilot analogy is a particularly good one because the reason pilots are so careful and they make sure they check their checklist and when they’re taking off, they know where they’re going to ditch, the reason is they’re on the plane and we are on the plane with our clients. Our wealth is with our clients’ wealth in this strategy. So we take great care in making sure it functions well.
Joe: Well, I love the book. It’s called Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times and Bad. A lot of the chapter titles crack me up and obviously we can’t go into nearly everything that’s in the book. So, where can people get the book? Wherever books are sold?
Michael: Yeah, Amazon. I’m not sure how many stores it will be in but it’s certainly widely available.
Joe: Awesome. We will have links in the show notes, StackingBenjamins.com. Thanks for hanging out Mike.
Michael: It was great. Thanks for having me.