By now, most of you know that finance is, well, strange. The basic concepts are easy to grasp, but once you’re ready to plunge into the world of investing, some of the principles involved seem to defy common sense. That causes investors to do what works in their head, but which ends up costing them a lot in the way of gains. Here are the most counterintuitive approaches to know about:
1. You need to sell off high-performing assets to rebalance
Consider a typical allocation of 70% equities, 20% bonds, and 10% cash in a $3 million portfolio. That’s $2.1 million in stocks, $600,000 in bonds, and $300,000 in cash.
After a few years, the stocks grow to $3 million, the bonds are up to $650,000, and the cash stays the same. This is now a $3.95 million portfolio. But notice that equities now constitute about 76%, while bonds constitute about 16.4%, and cash is just 7.6%. The portfolio isn’t balanced any longer.
So to rebalance it, you might need to sell off those stocks, and buy more bonds; and this is where it gets counterintuitive. Sell off the higher performing asset to buy a lower performing one? That’s crazy right?
But by doing this, you achieve two important things:
First, you maintain the risk levels. Equities are higher-risk than bonds, and your initial risk appetite accepted only 70% equities; not 76%. If you just “go with the winner” and retain the higher percentage of equities, you’ve likely lose sight of your initial risk assessment.
Second, when you rebalance this way, you keep to the principle of selling high (as the equities have appreciated) and buying low (as the bonds haven’t gone up as much in price).
This sort of behavioural discipline keeps the portfolio on-track for the long term, and avoids the classic gambler’s fallacy of “doubling down” on a winner. So it does make sense to rebalance in at least six-month intervals, even if you hate that “money conversation” with your financial planner.
2. Dollar Cost Averaging: it’s buying more of something when its price is dropping
Dollar Cost Averaging (DCA) feels a bit crazy on the surface. You’re buying more of a stock as the price falls, which sets off alarm bells: our every instinct is to not buy when we see the price steadily declining, week after week.
But it makes sense, if you don’t take a short-term view. DCA smooths out volatility, by spreading your purchases over time. Instead of making a large investment all at once, and potentially buying just before a downturn, you gradually build up your position – and you’re getting more of something when the price is lower. Conversely, you’re buying less of something when the price is higher. In that light, it might perhaps make more sense.
DCA is also typically done through automated processes, so it helps to take the emotional element out of. Otherwise, you’d be staring at price movements all day, trying to time when to buy when it’s low, and when to sell when it’s high. For single digit millionaires who aren’t finance professionals, it’s stressful; and it’s not a healthy drug.
That said, there are limits to this. There’s a difference between periodic price dips and a company fundamentally crashing, so don’t dollar-cost-average your way to oblivion either.
3. Barbell portfolio strategy: invest in the extremes
Common sense dictates that moderation is better. In most things in life, including investing, we tend to avoid extremes. A barbell strategy, however, does the opposite: it’s the complete exclusion of medium-risk assets.
The typical barbell invests a huge portion of assets (70 to 90%) in low-risk, absolute-return type investments (e.g., a Singaporean might use their CPF). The other 10 to 30% go into the direct opposite: crypto, wild business ventures, wine collections, Magic: The Gathering cards, etc.
This tends to result in a portfolio with extremely boring results for many decades (and boring, by the way, isn’t a bad thing in personal finance. If everything about your investing is exciting, you’re probably doing it wrong).
But every now and then, when a black swan event strikes, your high-risk portion might significantly outperform. For example: say you have 80% in CPF, and 20% in long-shot medical research firms. In the unlikely event that one of them discovers a cure for a kind of concern or diabetes or something, you would see massive outsized returns for a tiny risk of just 20%.
On the flipside, if the companies fail to discover anything important, you won’t be broke: the bulk of your money remains safely in your CPF.
The tricky part is acceptance: it’s entirely possible that you’re one of those investors who, throughout their entire investment horizon, will never see the black swan that makes your high-risk component excel.
Instinct is something for experts and professionals to trust
The layperson absolutely shouldn’t rely on their gut alone, or on what seems obviously rational. Put it this way: a PGA tour golfer trusting their gut can excel, but a new golfer should probably trust their caddy.
Give your financial planner, wealth manager, etc. a shot when they’re trying to explain the counterintuitive concepts. They do make sense, just from a time scale or angle that you might not expect. Also follow us on Single Digit Millionaire, for more information on breaking into the next tier of wealth.
