I Focus on What Matters
One of my esteemed X correspondents made a suggestion which, if you examine it closely, relates to what I discuss in “I have the Best Cash Flows.”
That’s because it focuses us away from the true investment problem, which is optimizing the composition of our portfolio at every cross-sectional moment in time. We optimize it so that the expected returns are satisfactory for our particular circumstances, knowledge, and personality.1
That statement was, in essence, “if you buy a little bit every week, you don’t have to think about the maximum drawdown level.”
Thinking about the maximum drawdown level is important, because making it shallower when it’s easy to do so greatly increases your overall compounding, and thus your overall returns. The simplified example in “I Have the Best Cash Flows” helps me understand this intuitively. Making drawdowns shallower also improves your overall stress levels, and thus your quality of life. It’s a big deal.
Focusing on having the best portfolio at each moment is the problem we solve to make the most money in markets. Therefore, we should think about how “buy a little every week” relates to this problem.
There’s no Time Like the Present
We seek to optimize each cross-section. In other words, what matters is the total composition of our investment net worth at any given point in time. Whether we add to the components “slowly over time” really doesn’t matter. How each cross-section is created matters less than what we end up with in our overall portfolio at a given moment.
Of course, we aren’t changing the savings portfolio every day. As long-term investors, we aim for “good enough” in general. This saves our mental energy to use where we are truly skilled to achieve great things with our brilliance.2 We invest in mostly the same way every month, so the proportions should not change rapidly over time.
Thus, our quality control only needs to check a few times a year. To set this up, we think about the current state of the savings portfolio and how it changes as we add to it over time. By carefully accounting for this in our plan, we are confident that our savings portfolio is in a good place without having to check frequently.3 People who check their savings portfolio less frequently get better results, all else equal.
Let’s use Tesla as an example. If a man owns 100% Tesla and it draws down 80% over the next year, he will feel the impact of that snapshot from a year ago, regardless of what he added in the interim. I guarantee you he will feel it. He feels it in his gut.
Because that is his money and it actually matters. If he makes the “cash flows” argument, he lies to himself and avoids looking at reality. His gut knows the score. My proposed solution is to understand how to make your forward-looking drawdowns shallower so that you make more money and, delightfully, improve your daily quality of life at the same time.
Does focusing on “buying a little at a time” help to improve this situation? No, as I said before, it focuses you away from solving the problem that matters. Let’s talk through some examples so it’s clearer to see.
Exploring Examples Builds My Intuition
There are two ways I imagine that focusing on “a little at a time” affects the average person’s investment process. The first is the “hidden correlation.”
Let’s say the asset in question is Tesla stock. Let’s say the investor maintains approximately 5% investment net worth in Tesla stock, 45% in Nasdaq, and 50% in bitcoin. Additional savings are added to the portfolio in the same proportion. Doing this solves our constraint of adding only “a little bit of Tesla every week.”
When Tesla draws down 80%, that “only” represents an overall portfolio drawdown of 4%. But this “small sizing” solution is a mirage.
Since Tesla is highly correlated to everything else in the portfolio, this portfolio still experiences a total drawdown around 80% over that one year. Using only “a little bit” of Tesla did not create the advantages of compounding that you gain by making your future drawdowns shallower. It did not solve the problem we most care about.
Here’s the other way I imagine this impacts the investment process. It’s easy to solve the drawdown problem by holding a lot of cash. So instead, our intrepid investor holds 5% Tesla stock and 95% cash.
She keeps adding to Tesla with her savings income, and gradually “ramps up” the amount over time. Maybe, every month, she moves the Tesla allocation up one percent as a percentage of her total savings portfolio. After four years she now holds 50% Tesla and 50% cash.
I’m not focusing much on the details of this plan. I’m sure there are smarter setups. The point is, if you think it through, you can easily solve the “drawdown problem” by holding plenty of cash.
However, this doesn’t optimize for making the most money for one simple reason. Assets outperform cash over the long run. Choosing to have a huge allocation in cash mutes overall investment returns by a lot.
So, in either case, the mindset doesn’t do a good job of leading us to make the most money. Which makes sense, as it focuses us away from the problem that actually matters to us: the problem of optimizing total portfolio composition at any cross-sectional moment in time.
I Put Myself in a Position to Succeed with Greater Understanding
Both of these plans also create significant behavioral dangers. As we know, people who don’t market time for a living are really not good at it. These portfolios give us lots of optionality that we probably want to take out of our own hands.
They create a great chance of making a change at the worst time. It’s an act of self-love to eliminate those future possibilities so that you are comfortable no matter what and get better results.
It is a matter of fact that people who hold the “all in tech assets” portfolio sell a lot into cash when a 2001 or a 2008 happens. By comparison, with a “good enough” portfolio, you hold the assets at the best time: when prices are the cheapest.
It is a matter of fact that people who hold a “boatloads of cash” portfolio impulsively buy into risk assets when a 2023-2024 happens. By comparison, a “good enough” portfolio has enough exposure to the market that you have less temptation to increase your allocation, letting you dodge catastrophic drawdown events.
You want to protect yourself from having to face those temptations unless you have serious market timing experience. That experience gives you the confidence you need to sit on your hands during roller-coaster moments.
The way to do this is not by “toughening up” and “telling yourself you have conviction.” This is all nonsense promulgated by people who are not trying to help you succeed. Conviction can’t be rented. It is earned through sweat, blood, and tears.
The way you get the best outcomes is by holding a portfolio you are guaranteed to be comfortable in during the most exciting market times. “I Have the Best Cash Flows” gives you one example of a simple cross-sectional improvement on an indefensible portfolio allocation, but there are many possibilities.
At the end of the day, it’s a personal journey, because you are guaranteed to hold the cheapest prices of your portfolio when you perfectly understand the assets you invest in. Tailor your allocation to your learning, and you will prosper. Just make sure you focus on solving the problem that matters.
See you underwater.
Understanding the last two helps us know which types of drawdowns we weather with ease, so we guarantee we hold for long-term gains as prices are cheapest.
People who don’t invest full time but ambitiously aim for better than “good enough” tend to send their results in the opposite direction.
At that stage, it’s only twice-a-decade events that make it worth our while to see if the proportions have moved far away from the usual balance.