You're Focusing on the Wrong Question | Victor Haghani on Why Static Allocation Fails

Here's a comprehensive summary of the YouTube video transcript, maintaining the original language and technical precision:

Key Concepts

Investment Decisions: What to own and how much of it.
Expected Returns: The anticipated profit or loss on an investment over a period.
Risk Management: Strategies to mitigate potential losses.
Dynamic Indexing/Asset Allocation: Adjusting portfolio allocations based on changing market conditions and expected returns.
Passive Investing: Investing in broad market index funds.
Active Investing: Attempting to outperform the market through stock picking or complex strategies.
CAPE Ratio (Shiller PE): A valuation measure that uses inflation-adjusted average earnings over 10 years.
pCAPE: A modified CAPE ratio incorporating dividend payouts and retained earnings adjustments.
Earnings Yield: Earnings per share divided by the stock price, the inverse of the P/E ratio.
Cost of Risk: The amount of expected return an investor is willing to forgo for a reduction in risk.
Risk-Adjusted Return: A measure of return that accounts for the level of risk taken.
Stock Buybacks: Companies repurchasing their own shares.
Permanent Portfolio: A diversified portfolio strategy with fixed allocations to stocks, bonds, gold, and cash.
Managed Futures: A strategy that invests in futures contracts across various asset classes.
Market Timing: Attempting to predict market movements to adjust asset allocations.
Financial Literacy: Understanding fundamental investment principles.

Summary of Discussion with Victor

The Two Pillars of Investing: What and How Much

The core of investing, according to Victor, involves two fundamental decisions: what to own and how much of it. While financial media heavily emphasizes the "what" (which stocks or assets to buy), the "how much" (position sizing and allocation) is equally, if not more, critical. Misjudging the "how much" can be severely detrimental, leading to either underperformance by avoiding risk or ruin by taking on too much.

The Journey from Active Trading to Passive Indexing

Victor's career began at Salomon Brothers and later as a co-founding partner at Long-Term Capital Management (LTCM). His early experience was focused on complex relative value hedge fund strategies and investment banking. However, after the LTCM collapse, he realized he lacked knowledge in personal investing. He observed the widespread adoption of the David Swensen-inspired Yale endowment model, aiming for alpha generation. After several years, he concluded that this approach, while potentially effective for institutions, was not suitable for individual investors, even knowledgeable ones. This led him to embrace simplicity, diversification, and passive investing in public market equities and fixed income.

Several factors influenced this shift:

Tax Efficiency: For US taxable investors, actively trying to beat the market is tax-challenged. Alternative investments and frequent trading are often tax-inefficient.
Legacy and Example: Victor wanted to set a sensible, long-term investing example for his children and future generations, rather than demonstrating a life dedicated to chasing alpha.
Systemic Failure: He highlighted a perceived failure in the financial education system, where personal investing principles are often overlooked even within leading financial institutions.

The Criticality of "How Much": Position Sizing and Risk Management

Victor emphasizes that the "how much" decision is paramount. Taking too much risk, even with good investments, can lead to ruin. Conversely, avoiding risk entirely can lead to significant underperformance.

He frames risk as a cost, akin to a fee. An investor should be able to determine, through introspection, what risk-free return they would accept in lieu of a higher expected risky return. This helps quantify the "cost of risk." The goal is to find the allocation that maximizes the risk-adjusted return.

Crucially, the risk-adjusted return curve is often parabolic and flat at the top. This means that minor deviations from the optimal allocation have minimal impact on returns, reducing the pressure to be perfectly precise. However, significant deviations, especially over-allocating to risky assets or leveraging excessively, can lead to substantial losses.

Valuations and Expected Returns: The pCAPE and Earnings Yield

The discussion delves into market valuations, particularly the CAPE ratio (Cyclically Adjusted Price-to-Earnings ratio). Victor views CAPE not just as a valuation metric but as a long-term expected return indicator. The earnings yield (the inverse of the P/E ratio) is a key component.

He introduces pCAPE, a modification that accounts for retained earnings. When companies retain earnings rather than paying them out as dividends, their book value and future earnings potential increase. The pCAPE adjustment aims to reflect this by increasing historical earnings figures to account for retained earnings, providing a potentially more accurate estimate of future earnings and thus long-term expected returns.

Historically, earnings yield has been a decent predictor of long-term stock market returns. For instance, an 8.5% earnings yield in 1900 correlated with a 10% long-term return, with multiples expanding contributing an additional percentage. While it's a predictor and not a perfect forecast, it provides a rational basis for estimating future returns.

The Importance of Expected Returns in Portfolio Construction

Victor argues that investing without considering expected returns is an "abrogation of duty." The ubiquitous 60/40 portfolio, he contends, is often implemented without any thought to expected returns or risk, simply as a default.

He notes that most prominent investment firms, when polled, converge on similar long-term equity return estimates, largely based on current earnings yields. This consensus provides a foundation for rational investment decisions. In contrast, retail investors often extrapolate past returns, leading to overly optimistic expectations.

Valuations and the Shifting Landscape

Victor believes that historical valuations, particularly from the first half of the 20th century, are less relevant today due to increased understanding of equities and changes in investment regulations. He also emphasizes the need to compare equity returns to safe assets, as interest rate environments significantly influence the attractiveness of equities.

He suggests that while current US equity valuations might be high, there are forces that could lead to increased equity issuance in the future, potentially bringing valuations back to more reasonable levels. He also expresses concern about the current low expected returns for US equities relative to their inherent risks.

The Impact of Stock Buybacks

Victor highlights stock buybacks as a significant, often underappreciated, driver of US equity market performance since the 1990s. He posits that companies buying back 3% of their stock annually could be pushing equity markets up by 3-5% per year. This occurs because buybacks reduce the supply of shares, and if investors maintain fixed asset allocations (e.g., 60/40), the market must rise to accommodate these buybacks without altering their stock-bond mix.

He also points out the tax advantages of buybacks and the potential loss of tax revenue for the US Treasury. Interestingly, he notes that index funds can mitigate some of the upward pressure from buybacks by selling shares to buyback programs, thus distributing the impact more broadly.

Building Portfolios: Simplicity and Diversification

At Elm Wealth, portfolio construction prioritizes:

Screening: Investing in assets with a justifiable risk premium that can be calculated and accessed at low fees.
Low Fees: Minimizing expenses is crucial for long-term returns.
Tax Efficiency: Especially important for taxable accounts.
Non-Zero Sum Strategies: Avoiding investments where one party's gain is another's loss.

This leads to a focus on low-cost, broad-market index funds for both risky and safe assets. The world is broken down into approximately 10 buckets (e.g., US equities, European equities, EM, developed Asia, T-bills, TIPS, nominal bonds).

The allocation process involves:

Baseline Setting: Establishing a baseline expected return and risk for each bucket.
Dynamic Adjustment: Overweighting or underweighting buckets based on their current expected return and risk relative to the baseline.
Risk Measurement: Using a one-year moving average of momentum as a proxy for risk. In high-risk environments, exposure is reduced by a third; in low-risk environments, it's increased by a third.
Fixed Income Allocation: A smaller allocation within fixed income is also dynamically adjusted based on risk/momentum relative to T-bills.
No Leverage: The ETF does not employ leverage.

The portfolio is rebalanced weekly, but in a "slow-moving" manner, adjusting a quarter of the way back to target each week to smooth out trading activity.

Challenging the Permanent Portfolio and 60/40

Victor criticizes the Permanent Portfolio for the same reason he criticizes the 60/40 portfolio: it's not based on expected returns, risk, or covariances. While the ingredients (stocks, bonds, gold, cash) might be reasonable starting points, the fixed 25/25 allocation is arbitrary and unlikely to be optimal. He advocates for building portfolios based on calculated expected returns and risks.

Managed Futures: A Potential Addition

Victor has a "soft spot" for managed futures, acknowledging their potential for low costs and uncorrelated returns, especially during market drawdowns. However, it doesn't fit Elm Wealth's strict criteria because it's difficult to independently verify expected returns beyond historical performance, and fees, while potentially low, are still higher than their target of around 5 basis points for underlying ETFs. He views it as a reasonable option for clients if implemented with extremely low fees and avoiding illiquid markets.

Dynamic Asset Allocation ETF

Elm Wealth's ETF, launched in February, is a conversion of a private fund dating back to 2011. It follows their dynamic index investing approach, starting with a 75% equity, 25% fixed income baseline. Allocations are adjusted based on expected risk premiums in equity buckets and risk levels (momentum proxy). The residual is allocated to fixed income. The ETF has approximately $500 million in assets under management with a total expense ratio of around 24 basis points. Victor notes the significant disparity between asset allocation mutual funds ($3-4 trillion) and asset allocation ETFs ($10 billion), attributing this partly to the 401(k) structure favoring mutual funds.

Market Concentration and Low Expected Returns

Victor is more concerned about the overall level of low expected returns in the US market than the concentration in large tech stocks. He believes it's difficult for corporate earnings to consistently outpace GDP growth at the rates implied by current market expectations. He finds it "scary" that investment professionals are largely acknowledging these low expected returns (1-2% above Treasuries) but are not dramatically adjusting asset allocations. He also questions the logic of companies like Oracle and Meta issuing debt while simultaneously buying back stock at current market levels.

The "Buybacks in Reverse": Equity Issuance

He views the potential for large private companies to go public as a "buybacks in reverse." If buybacks can boost markets by 3-5% annually, significant equity issuance could have the opposite effect. He also notes that buybacks tend to cease during periods of high uncertainty, and the market's reliance on them is a point of concern.

Contrarian Beliefs and Core Investment Lessons

Victor's contrarian belief is that investors are not willing to change their asset allocations dramatically in response to changing expected returns or risks, often conflating dynamic allocation with bad market timing. He argues that it is rational to adjust allocations based on market conditions.

His core investment lesson for the average investor, borrowed from Matt Levine, is: If offered an investment with a 20% return and virtually no risk, assume the person is lying or doesn't understand the situation and walk away. This encapsulates the importance of risk, market efficiency, and skepticism towards unrealistic promises.