Although the idea was introduced in 1952 by Harry Markowitz (who got a Nobel for it), it still doesn’t get the central focus it deserves in investment planning. Like the efficient market hypothesis introduced by Friedrich Hayek seven years earlier (who also got a Nobel for it), it is a very useful theoretical model to understand the relationship between investment risk and performance, but should not be abused by failing to question whether its underlying assumptions hold true in particular cases.
Let me try to explain the basic idea of MPT with a simple example:
Suppose you want to start investing with $100. You could choose to put all $100 in Apple’s stock. Your portfolio will then depend entirely on how Apple performs in the future. It’s done great in the past, so it might continue to gain value, or the iPhone 8 might be a disaster, and you will lose everything. Investing in any single company is a high-risk investment because you’re putting all your eggs in one basket.
If you wanted a safer portfolio, you could put $50 into Apple and $50 into Amazon. Now you have a similar expected return, but much less risk. However, the fortunes of Apple and Amazon are still highly correlated because they are both tech stocks, and they tend to move up and down together. If the tech market crashes, you will still lose a lot of money.
What you could do is put half your money into Exxon, which is less likely to match the performance of tech stocks, and so will provide similar returns with a lot less risk. You could take this strategy further and split your $100 into 25 different stocks in all kind of sectors such as industrials, healthcare, and utilities, and include some international stocks as well. You might put some of your money into bonds, which are much safer (you only lose your money if the company or government goes bankrupt), but provide a lower return.
Here’s the key insight of MPT: you can graph all possible allocations of a set of investments on an efficient frontier: a line (actually a hyperbola) which represents a combination of investments that has the least risk for a given level of return. From a safe 100% bonds portfolio to a risky 100% stock portfolio, every point on the frontier represents the highest return for a given level of risk. The degree of risk you’re willing to tolerate depends on your personal preference, but you should always try to maximize your return for whatever risk tolerance you choose. You achieve that by having a well-diversified portfolio where no single asset represents more then 4% of the total, and the correlation between assets is minimized.
Here is another insight of MPT: you can often lower your risk with a small degree of diversification. By putting 25% of a portfolio into international stocks, a little in alternatives such as real estate, and a little in bonds, you greatly lower the risk, with only a slight decrease in the expected return.
Below, I show you exactly what this looks like for my portfolio.
The catch is that the efficient frontier is based entirely on historical performance, so if the market behaves dramatically different than it has in the last 100+ years, your assumptions won’t hold true. Furthermore, it is not a set-it-and-forget-it approach: you must continually update the model based on market performance and re-balance your portfolio to keep the ideal asset allocation. This is a lot of work! In fact, it’s more work than the average investor is capable of, which is why I don’t recommend that individual investors buy individual stocks. Instead, you should either buy a few ETFs which represent entire markets, or let a robo-trader do it for you. The ETF approach could consist of just three securities: a domestic market ETF, an international market, and a bond ETF. A robo-advisor would do the same thing, only more efficiently (so less risk, lower taxes, and potentially higher returns), but for a small fee. (I use Personal Capital, but Betterment.com is cheaper for new investors.)
Here’s what an efficient portfolio looks like for me. If you own stocks or a 401K, etc, I suggest you sign up for the the free Personal Capital app, so you can see whether your portfolio is efficient.
1: How you invest is far more important than what you invest in
Most investors believe that the job of a investment advisor (or a personal investment strategy) is to look at the thousands of securities (stocks and bonds) and pick “winners” rather than “losers.” The better an investor’s talent at picking “winners,” the faster his portfolio grows. Other investors think the market or economy has predictable cycles, which one can take advantage of to earn superior returns.
2: Amateur intuition is a terrible guide to investing
Most amateur investors who pick stocks significantly underperform the market. 90% of people who pick “winning” stocks do worse than if they picked them at random. There are many reasons for this: (1) your emotions will work against you — you will be tempted to buy high and sell low, (2) even if you correctly identify a good stock, it is much harder to evaluate if it is already priced too high and (3) unless your have exceptional talent, the collective wisdom of the market will be superior to your predictions.
It is possible to outperform the market, but it’s not a simple or quick process:
Buy and hold those stocks for years (or decades) until you achieve a return in your investment
Monitor those companies and sell stocks if their fundamentals change.
Repeat the process with several dozen stocks so that you’re not overly exposed to any one company
This “buy and hold” strategy is more profitable than frequent “active” trading, but it requires hundreds of hours of study, more risk, and a lot of practice. Even if you do everything right, you will only earn slightly more than picking stocks at random. A “set it and forget it” strategy of investing in broad indexes is far easier.
Furthermore, even if you think that you have a superior understanding of market fundamentals because of your economic theory or insider knowledge of your market, that’s no guarantee of superior returns:
For example, if you follow Austrian economics, you might think that your understanding of why business cycles happen would lead to superior returns. However, you may have noticed that most Austrian economists are not millionaires. That’s because the results of most macroeconomic policies play out over decades, and simply staying out of the market because you think it may crash in the next 5, 10 or 20 years is worse than keeping your money in the market. The timing and severity of crashes is impossible to predict, and most are followed by a sharp recovery. The best strategy is usually holding on for the long run.
Likewise, even if you understand an industry well enough to pick winning technologies, there’s no guarantee that the first mover will execute them best. It’s possible to be a great futurist at predicting future trends and yet completely fail at predicting the companies which will profit at exploiting them.
3: Expert stock-pickers won’t do better than you
There are at least four reasons why the average small-time amateur investor can get a better return than by delegating the job to a professional manager:
1: The more effort is spent on an actively managed portfolio, the more that manager has to be paid: whether it is a mutual fund or a personal broker, the more work the manager has to do, the more he’s going to charge you for it. Since he’s unlikely to do much better than the market, he’s just as likely to hurt your total returns as to help.
2: The more popular a fund becomes, the more difficult it is to outperform:
The more popular a fund, the larger its value. For example, Fidelity Contrafund (FCNTX) has a net worth of $80 billion. A manager of an $80B portfolio cannot bet on a few promising startups because investing billions into a small company will drive up the stock too much. He’s forced to invest in large S&P 500 corporations and dilute his strategy investing in many companies. The larger a fund becomes, the more its performance tracks the overall market.
3: A consequence of getting too popular is pressure to match the index: high returns require taking bigger risks. A small fund can afford to do that, but an $100B fund is too big to fail — there will be too many angry investors when $20 billion of shareholder value is wiped out. This forces fund managers to insure against underperforming their indexes and discourages risk taking.
4: Unlike hedge funds, mutual funds are required to disclose their holdings, so anyone can copy the strategy of a successful fund. While some funds might be unusually successful because of innovative strategies, investors can’t be sure of that until they have a proven track record, by which time the market has copied and diluted their advantage.
Thus, a common pattern is:
A managed fund outperforms the market
More and more people buy into the fund and copy its strategy
The fund becomes too big and stale to profit from its original values
Studies show that the overall effect after taking costs into account is that managed funds slightly underperform indexes. By investing on your own in cheap index funds, you can keep your costs low and match your target asset class.
4: High-performing investment categories are not legal unless you are already rich
So far, I’ve presented a pretty pessimistic view on the notion “beating the market.” If you can’t do better than the experts or actively trading on our own, is there any way to get superior returns?
There are investment vehicles which may outperform the market, but they are only available to accredited investors – those with over $1 million in assets or $200K in yearly income. You must be an accredited investor to invest in venture capital, hedge funds, angel investments, and other alternative investments such as financial instruments based on loans, legal settlements, and crowdfunded real estate.
Alternative investments might return above market returns and they can offset risks from investing in the market through because they are allowed to short the market, etc. Unfortunately, most western countries have decided that non-accredited investors lack sufficient financial sophistication to understand and take on the risks.
Small-time investors seeking superior returns do have a way to seek superior returns: you can become an entrepreneur by starting your own business or buying property. If that does not appeal to you, it’s best to resign yourself to buying in for the long run and getting rich slowly.
5: Sound investing is fundamentally about managing risks, not picking “hot stocks”
There is no particular stock, bond or industry which can predictably be counted on to return above-average returns. In other words, you’re likely to make just as much money investing in high-tech startups as plain old boring utility companies. However, if one looks at broad asset classes, one can see a certain pattern. (Asset classes are categories such as domestic vs international stocks, large vs. small companies, or value, growth, or income stocks.) Research shows that over the long run, all stock-based asset classes earn similar rates of returns.
There is no free lunch in investing. Higher returns come with with higher risks (year by year variability). Some asset classes (such as stocks) historically have higher returns than others (such as bonds), but usually with higher risk. An investment strategy should match your values and financial goals – not guarantee a particular rate of return. Given a particular tolerance for risk, your portfolio should maximize returns while minimizing variability.
A diversified portfolio (one which invests in securities of different kinds to minimize their correlation with each other) will give annual returns mostly consistent with the overall market, but with less variability. As a rule of thumb, no single security should be worth more than 5% of your portfolio.
In short: don’t stress too much about what you invest in – just don’t put your eggs in any one basket: spread your investments over many securities in different asset classes.
Below: my portfolio is diversified by market sector, asset class, and capitalization (not shown).
6: It doesn’t matter if you are up or down
Even experienced investors can get caught up in the emotional rollercoaster of markets: markets move up and down in unpredictable swings, and individual portfolios reflect that trend. On average, the entire stock-market gains 5-7% per year – that’s what you would earn if you picked stocks at random. When evaluating how your stock asset-class is performing, it is important to compare it to the stock-index rather than the absolute number. If the market is up 15% in a year, a 10% return is not actually that great. Vice versa, if you lost 10%, but the market crashed 15%, your portfolio might be OK. Similarly, other compare each of your other asset-classes to a relevant index.
Judge your performance by comparing it to the indexes of the asset classes that you are targeting: for example, a portfolio split between the S&P 500 and international equities should take the average of both when evaluating how well it performed. If you are keeping up with your benchmark index, consider yourself lucky — most investments underperform. If you are losing money when markets make a positive return, it may be time to change your strategy. Only if you consistently out-perform your target index can you conclude that you’ve picked a superior strategy.
Don’t try to pick “hot” stocks or time the market
Build a diversified portfolio by investing in individual stocks in diverse asset classes, or index funds which track the market
Minimize costs by avoiding managed funds, investing in low-cost ETFs, and trading infrequently
Buy for the long term: don’t sell your investments until you need the money
Furthermore, the lack of good money habits cut across all income levels. I have friends who make far more money than me, but recently complained that they could not take advantage of Amazon Prime Day discounts because pay day was too far away. Friends who amass huge bank accounts, where their money slowly rots from inflation, or gets invested into CD’s, or useless and expensive mutual funds. Friends who panicked when the market crashed, and converted their securities to cash at the worst possible time.
Americans, you can do better! You can save and be a successful investor without becoming an expert or hiring one. By my estimate, a majority of American households would be worth a million dollars by their 40’s if they start early and make a concerted effort. There are three parts to maximizing your net worth: (1) maximize your earnings (2) minimize your cost of living and (3) maximize the return from your investments.
I will share my financial story so you can see that that I learned these lessons the hard way.
First, I invested my student loans in the stock market – in the early 2000’s
I purchased my first mutual fund at 15, with the first $500 that I earned. That was a smart start, but I followed up with a common setback: I wasted 5 years of my life getting three useless university degrees. A university degree may be necessary for many careers, but in my case, I learned virtually nothing that I used in my career as a software developer. I made university as cheap as possible by going to a state school and applying for tons of scholarships. I saved money by not having a car until I was 24, worked as a student worker, and had summer jobs. Because I lived so cheaply and worked while at school, I was able to invest my student loans in the stock market, which as you may recall did not do very well in the early 2000’s. I sold my stocks and paid off 100% of my student loans when the interest-free period elapsed, and decided to go with a professional advisor from then on.
Then, my broker bet everything on sub-prime mortgages
From 2005 to 2007, I lived cheaply and I sent a significant portion of my income to a broker. Whatever he was doing seemed to be working. What I did not consider is that the market itself did very well – I failed to compare his returns with overall market performance. When the recession hit in 2007, I lost over 60% of my original investment. Only later did I learn that he invested in subprime mortgage REITs that gave him kickbacks in the form of commissions. His incentive was to sell me funds with the highest commission – not those that controlled risk or maximized my return.
So I fired the professionals and make a killing investing on my own
After watching my life savings dwindle away for all of 2008, I created a forum thread with a investment strategy based on Peter Schiff’s Crash Proof in January 2009. I transferred everything to E*Trade and invested almost every penny I had in the markets. My return for 2009 from my investment fund was 58% – I made back everything I lost in 2008. That was a good start, but it was only a start. I invested very little additional capital over the next several years because I started spending most of my money on a nice car, restaurants, a fancy wedding, and an apartment that was soon overflowing with stuff I barely used.
Then I got rid of all my possessions, moved to China, and adopted a minimalist lifestyle
In 2010, I was making a good income working for an big-name ad agency in midtown Manhattan. I was making great money, but I was not very happy. I worked crazy hours and never saw my wife. The cost of life and taxes for a NYC resident are crazy high, and my friends and relative rarely had time for a vacation. I wanted to see more of the world while my wife and I were still young.
So, I found a job in Shanghai, China. It paid a fraction of what I was earning, but my wife and I decided that life is short, and if we did not see the world while we could, we would always regret it. We only brought with us what we could fit into the two suitcases allowed by the airline. Once we got to China, we knew we would have the same limitation when moved on, so we decided not to buy anything we could not carry when we moved to our next destination. Over the next five years, we lived in a series of tiny apartments in central Shanghai (one of the most expensive cities in the world). Yet because we had so few possessions, we felt liberated, not constrained. We found that we did not miss the vast majority of our stuff, and we could move anywhere in the world with just our baggage.
After five years, we decided to move back to the USA. We were able to fit all the possessions for three people in standard airline baggage, plus five medium boxes than we shipped via China Post.
I let a robot manage my life savings and worry about the details
When I returned to the USA, I reviewed what my ETrade account had been doing while I was in Asia. I saw that it had grown badly unbalanced – investments that had been successful dominated my portfolio, and moved me away from my intended strategy. To stay true my plan, I would have to re-balance my portfolio multiple times per years, buying and selling many stocks and driving up my costs. That’s when I decided to switch to a robo-advisor, which would implement my strategy automatically, while minimizing taxes by investing funds in the right tax-category and performing tax loss harvesting. After some research, I decided to go with Personal Capital, although there are several cheaper options if you don’t care about having access to a personal advisor when you want it.
Summary: how to make a million bucks by age 40
Here is a summary what I’ve learned over the last 10 years:
Take responsibility for your own career
Develop money-saving habits
Don’t let your possessions control you: adopt a minimal lifestyle
Get rich slowly: select your trading strategy, then automate it
1: Take responsibility for developing your career path
Remember that your career is an enterprise. If you want to increase your compensation, you must increase your value to your employer. Do what employer asks, but also discover what builds value for your employer and focus on that. Keep in mind that making the value you create visible within your company is your responsibility. Stay on the market and explore new opportunities even if you are happy where you are – this will help you understand your value.
If you get in a rut, be entrepreneurial: there were several times in my career when I felt stuck in a job or a position that either didn’t have the career path that I wanted or did not pay what I was worth. I took on several freelance projects that boosted my income or helped me leverage into a career shift. It’s not hard to find these opportunities if you’re always looking for them.
To visualize my financial status, I use mint.com and personalcapital.com to track all my expenses and investments. (Mint.com is better at tracking personal expenses and keeping a budget, while Personal Capital is better at more complex situations and investments.) I can quickly identify if a spending category is out of normal range, and I don’t forget about recurring expenses and subscriptions. Mint.com also gives me a nice graph of my net worth from 2008 to today, which helps keep me motivated.
I understand that my possessions can be replaced. Someone recently asked me what I would grab if my apartment caught fire. “Nothing,” I responded. “Everything I own is replaceable.”
Minimalism is not a radical lifestyle. Minimalism is a tool I use to get rid of unnecessary stuff and live a meaningful life—a life filled with happiness, freedom, and conscious awareness. Because I strip away life’s excess, I’m able to focus on the important parts of life: health, relationships, passions, growth, and contribution.
Here are some ways that a minimalist lifestyle saves us money:
By keeping possessions to a minimum and owning only what we use, we avoid the need to use a garage or spare room for storage. We can easily fit everything we need to live in a small apartment
If we really need something we don’t have, we borrow it.
We buy very little prepared food. We (well, mostly my wife) can make just about anything from a small set of ingredients. Raw food is cheaper and the result is healthier.
We visit our library to borrow books, e-books, and movies, as well as passes to local parks & zoos
We work out at home using body-weight exercises and swim at the apartment’s pool – no gym memberships needed.
We buy our daughter’s clothes from resale shops and sell them back when she grows out of them.
We have a capsule wardrobe. Everything hanging in my closet right now is for use during this summer. Clothes for other seasons are in storage. I don’t own anything I won’t wear over the course of a year.
When we moved to China, I digitized all my books by sending them to 1DollarScan.
I can fix shoes, furniture, and most electronics. (It’s not hard to learn.) I buy nice shoes and resole them many times before I wear out the upper. I know how to replace a fuse in a microwave, change the air filter in my car, and I own a glue for every material in the house. I know how to Google repairs — and I know when to let the experts handle them!
Don’t buy a home:
The New York Times has a great calculator for whether buying or renting makes sense, but if you’re working hard for that million, it generally does not. Yes, buying will generally save you money over renting in the long term, but consider this:
Even if you could buy a new house with cash, chances are that your investments will appreciate far more than your home. So you have to take out a mortgage. Now you have to worry about the costs of buying the home, paying the mortgage, performing maintenance, and big hassle if you want to move somewhere else. It’s better for you to stay flexible, focus on your family and career and let someone else take care of all the maintenance. (Another great perspective on this.)
4: Get rich slowly
After maximizing the spread between your income and your expenses, you need to leverage the magic of compound returns by investing it in the market.
So my suggestion is: just invest in the market. The whole market, not just the S&P 500. You can either invest in an index fund like VTI (USA) + VEU (not USA) or use a robo-trader which buys individual stocks (this can lower costs and save on taxes). I use Personal Capital. I can’t speak for other robo-traders, but Personal Capital re-balances my portfolio not only by asset class, but also by market sector, so I’m positioned to benefit from growth in any industry.
The only two questions you need to decide are: how to split domestic versus international stocks, and what to invest in alternative investments (such as gold, REITs, and Bitcoin). If you have trouble with these questions, use the default from a robo-trader, or use my strategy:
My portfolio asset allocation:
Allocation by sector (industry):
An aggressive portfolio can “beat the market” while controlling risk but that’s not the primary goal:
Can I really make a million by 40?
The average historical market return is about 10.7%.* A 10.7% return means your money will double every 6.5 years. If you start investing at age 20, and invest $16,300 each year, you can expect just over a million dollars by 40. Saving $1360 per month is not possible for a typical American, but becomes doable if you follow the career and lifestyle principles mentioned above. (Delaying the start of your career with a college degree would push your million into your mid 40’s.)