One observation that I can make: I am constantly surprised by which of my posts seem to attract the most attention, and the ones that seem to gather little. If I put an ‘importance rating’ on each and asked my readers to do the same, I wonder how well they would match?!

Thanks again for putting ‘pen to paper’ … keep it up! AJC.

Let me give you an example.

I was heavily short many bank stocks starting in July. At some point I had more than 40% of my portfolio dedicated to various shorting strategies, based on much analysis of what was going on. A fair amount of that 40% was leveraged with options and 2x ETFs as well.

Then, as you may know, in September, the government decided to ban shorting any and all bank stocks. I was completely burned out at this point, panicked – and the following day closed all my shorts, keeping only some long positions which I deemed “safe”.

Over the ensuing two months I watched in horror as I saw my shorts would have netted a 30-40% portfolio return, but I instead netted a 10% portfolio loss on my longs! I was so afraid of losing money, and yet my behavior ended up causing exactly that. And like a deer in headlights I couldn’t muster the courage to short the market as it slid forward in those two months.

What’s the moral of this story? In my view, anyone who wants to follow this blog’s stated goal, aka “7 million in 7 years”, and expects to use the stock market as a tool to achieve that purposes – MUST have a resonably high risk tolerance. The ones who succeed seven years from now will not be the smartest ones, or the ones who figured out the best system, the best portfolio probability curve. They will be the ones with decent systems and discipline but outstanding ability to stand tall in the face of enormous adversity (aka portfolio losses).

That equates to high risk tolerance. Which is ok, because after my adventure, I now firmly believe risk tolerance can be learned and is not innate. It can be managed, practiced and developed. And learning risk tolerance probably involves having to go through a few heavy losses to learn the process. I lost maybe 70,000$ in the stock market now – a substantial part of my net worth. But you know? I realize, I’m still here, I’m still standing, and losing 70,000$ sucks A LOT – but I’m not dead for it. It’s no longer an unknown.

Just my two cents! Engaging in intelligent, risky behavior is what this blog is all about in my view .

Keep up the good work.

“- if you mix in high(er) return options (e.g. small cap) your RISK goes UP”

Generally, this is true. There are a couple of exceptions:

1) If two asset classes are negatively correlated (have a tendancy to move in opposite directions during the short term, but over the long run provide their historical return) then your risk will go down even if you diversify into higher risk asset classes. The hard part is finding two asset classes that have been negatively correlated, and even harder to predict them going forward…

2) This often used example, adds a small amount of equity (SP500) to an all bond portfolio. As you would expect, the long term return of the portfolio increases…but the long term risk decreases, e.g., with a 90-10 bond-stock split, or stays the same, e.g., with a 80-20 bond-stock split. This is one of the only “free lunches” in investing that I’ve read about that appears to be easily repeatable going forward.

The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on. Put a differently way, if you tried to find a single investment that provided the same return as a diversified portfolio, it would most likely have a higher associated risk, and if you tried to find a single investment with the same risk, would most likely provide a lower associated return.

This, of course, doesn’t mean anything unless the new return is something that you desire.

- if you mix in high(er) return options (e.g. small cap) your RISK goes UP,
- if you mix in low(er) risk options (e.g. bonds) your return goes DOWN

Efficient market theory says that this MUST be the case

Asset classes like US Small, US Value, US Small Value, Emergining Markets, Foreign (Non-US) Small, Foreign (Non-US) Value, etc, all historically have higher long term returns than the SP500. Just mix one or more of these with the SP500, and the diversified portfolio will most likely beat the SP500 over the long run.

I think you’ll be hard-pressed to come up with an average CGR of 11.9%, with only TWO 30 years periods as low as 8%. So, where does the higher risk lie?

But, isn’t setting a strategy based upon risk rather than financial objectives putting the cart before the horse?

“Considering that I am ‘diversified’ on the London, New York, and Australian stock exchanges – and, in the tank on all three (for different timing/reasons) – I would have to disagree with this theory”

I’m sorry you are in the tank, but I don’t see how this short term event disproves a long term theory.

“All we achieve by ‘diversifying’ from an investment (and market) that we know/understand/love is to lower our long-term returns, so I have to stick with my no diverification/rebalancing mantra.”

You are assuming that you would always focus your investment on the better performing market. If you focus on an underperforming market, a diversified portfolio (with rebalancing) would provide increased return, probably with lower risk.

The question is, for your holding period, can you consistently identify which market will outperform a diversified portfolio beforehand?

[Note: Picking individual stocks is a whole different game, as the long term expected returns are much more speculative]