Schwab Rolls out New Ad Promoting Stock Balancing
Seeing a company like Schwab running an ad encouraging investors to diversify by balancing stocks and stock sectors may not appear noteworthy, but it certainly is.
Small children will often ask why when you tell them something, and as you try to explain it to them, they will often just keep asking why to get you to actually explain it to them well enough. Ultimately, we often tell them that the reason is because I told you so, although that doesn’t satisfy them, nor should it.
As they grow older, that’s what they end up doing, just accepting what they are told, once they stop asking why that is. We should never lose our desire to ask why though, and should never accept that we are being told so without the need for good reasons or reasons at all as sufficient.
When a broker such as Schwab tells us that we should not focus on one type of stock or sector, and instead seek to maintain a much more balanced portfolio, and rebalance this regularly, we may just want to accept this as truth. Doing that without question is always a mistake though, as even if the advice ends up being eminently sound, it may not be, and there’s no way to tell if we don’t ask why.
This idea has been around for a long time though, and didn’t come from Schwab of course, although like a lot of bad ideas, people not asking why enough has allowed it to persist right up to this day, as we clearly see.
This new ad of Schwab’s just tells us to do it, where they tell us that this manages risk and therefore is wise, without going into the matter further. Never mind that they don’t have time in this short commercial to go into the matter, as no one is. As it turns out, whether this is a sensible strategy or not is not so obvious, but we will never know any of this unless we ask and unless we actually think about it enough.
At a minimum, we need to conjure up our inner child and use that powerful three letter word, why. We need to see their cards on the table to figure out whether this is a good hand or not. They aren’t showing it to us and just expect us to believe them, but that should never do. They don’t really know what cards they hold either as it turns out, because they haven’t asked why either. The cards sit face down, with no one wanting to reveal them it seems, but we must.
The goal of this strategy is obvious, which is to try to prevent being in positions that may look good now but may turn on us, and we’re then supposed to reduce the risk of this by spreading things around more. We’ll have a look at this to see where it might make sense and where it may not, to decide if we want to place our bets on such a hand.
We break down price risk with stocks into three main categories, company risk, sector risk, and market risk. We manage company risk by holding an assortment of other stocks, sector risk by holding stocks in different sectors, and market risk by holding other assets besides stocks.
To flesh out how good a hand they have, we need to start asking some real questions. We cannot just settle for something that manages risk, which is the sole goal of this strategy, we also want to manage it the best way.
Whenever we are discussing risk, we need to do our best to understand it, which includes both defining the risk an also looking at various ways in which it can be managed, leading to our selecting the best course of action.
Some risk cannot be managed on the fly. If we wake up in the morning and look at our positions and see that we have been hurt in a way that we could not have anticipated, we are stuck with the situation and need to decide what to do next.
We might automatically think that we would be better off spreading things around to better manage these things, but this cannot just be viewed in isolation, as we always need to have at least a sense of what the opportunity costs will be. Burying your money in the back yard will protect you against all these risks, even though there is still the risk of someone stealing it, but it does get rid of all stock risks to be sure since you aren’t invested.
This also gives up the opportunity to grow your money though, and we cannot rightfully address risk without also considering the other side of this coin, the return side. There will be a path that ignores risk and completely pursues return, and that needs to be our starting point, where we then decide the cost of various risk reduction strategies and choose the one that allows us to pursue our goal in an acceptable manner.
When we just arbitrarily choose a risk management strategy with no regard to returns, we throw away our central objective, the reason why we invest in the first place, to grow our money. Growing our money has to be the primary directive, and then manage risk in a way that will allow us to pursue the highest returns we can with the desired level of safety.
The equilibrium here is reached where the costs of eliminating the risk and the costs of the risk are equal, where looking to take on more risk or less risk will hurt us marginally. We do not require any real precision here, but we do want to at least be in the right neighborhood and not just be content to live in the slums.
The only risk that we need to make preparations for is what we can call shock risk, the risk that happens outside of our ability to manage it incrementally. By definition, we can manage the rest. Beyond this point, the risk is our not managing risk properly on the fly, which is certainly a risk and a big one for a lot of investors who are content to just play blind man’s bluff instead.
Most shock risk of a magnitude that should concern us is market risk, where having your money in different stocks or sectors really isn’t going to protect you. This takes us to the backyard scenario if we just want to avoid this, as this cannot completely be eliminated. The backyard approach also involves adding a bunch of old wrecks, bonds for instance, to clutter up our yard and bring our property value notably down.
Wanting Junk in our Portfolios Comes at a Big Price
If people only knew how much having this junk in our yard harms us, involving the permanent placement of these hedges, they would stop immediately and never go back. This is not to say that bonds don’t have their place at certain times, but buying them and just parking them in the backyard is not one of them, as doing this seriously drags down our performance without providing any benefits at all when we are in a bull market, in other words, when we should be in stocks instead.
The risk after we perceive a shock can be managed though, by simply reacting. These things also do not arise completely out of the blue, as the road to the shock is generally pretty well paved. These things also occur much more in bear markets, at least the shocks that investors need to be concerned about, which are the biggest of them only and not the wiggles that we see on the path to long-term growth.
We’re not talking big moves down that unfold over time, and when we measure the magnitude of the immediate shocks we get, we find that they are not sufficient to even concern us very much, and even beneath the threshold of how much investors need to see to want to exit. These are instead just warning signs, and avoiding them provides very little benefit indeed and is simply overwhelmed by the costs of protecting against this, the sacrificing of performance that we agreed to when we selected variety for its own sake.
Our first and only line of defense is to maintain vigilance, and react appropriately to changing conditions. If a real bear market is already underway, we may not even want to be in stocks at all, and being in several sectors and losing money with all of them is not a solution at all to managing drawdown from market risk. If the risk is to the market, and we want to avoid it, we have to pull back from the market to do it.
Looking to protect against the real risk here, the market shocks that do come out of nowhere, just isn’t going to be something that we can manage without paying a huge price, one that is way out of proportion with the potential benefits of this. When this happens and we wake up to a shock big enough to matter, all we can do is deal with the aftermath and accept this risk as just the price for doing business, but if we are willing to accept far inferior results to provide a little insurance against this, the cost to benefit ratio becomes not only excessive but ridiculous.
That’s not how we tend to do it though, and when the crap hits the fan, we just watch things continue to unravel and replace action with hope. This is a big risk indeed, but we should never choose to water down our brew so much to seek to compensate for a bad plan. We instead need to seek to fix the plan and have it doing what it is supposed to, managing our risk well or at least sensibly while pursuing returns, the forgotten part of all of this.
The same principle applies to sector and company risk, although these are even more telegraphed than market risk is. The reason is that these risks arise out of changing business circumstances, which transpire more incrementally, rather than things that actually do hit us out of the blue.
All of these risks can and need to be managed in real time, where our decisions are shaped by changing conditions, as all risk management requires. If we instead choose a path that ignores these conditions, we cannot even be pretending to help ourselves. If we wish to invest but refuse to help ourselves when we need to, we will deserve the poor results we get.
It turns out that Schwab’s recommendations do address risk, but the actual risk here is the presumption that we will see events change and not do the right thing, which may indeed be significant. This does not address shock risk but instead involves the tendency to mismanage risk overall and suffer from the cumulative effects of it.
This is a terrible way to manage risk, having us pay a big price in forsaken returns to compensate for poor decision making, where we actually are willingly accepting a strategy that not only slashes our returns but increases our losses when things do turn sour.
This not only has us including a lot of stocks of lesser potential, we’re also supposed to balance things by taking money from our good performers and feeding it to our bad ones. All you need to do is add the force of momentum to this, the force that drives the prices of stocks, and we end up balancing things to decrease the impact of our winners and increase the losses with our losers. At the end of the day, we count things up and are no more the wiser because we have no idea what we are doing.
The fact that this is considered the gospel truth by Schwab and the industry as a whole is what is really noteworthy, with the masses just following their teachings without really thinking about the matter at all.
Why, Mr. Schwab?
Let’s revisit our inner child again and start asking some more questions. Why would we not want our money in a single sector, Mr. Schwab? Because the sector might cool off and have us start losing money with it.
Should we even be holding this sector at all at that point though, Mr. Schwab? Should we be so comforted by holding sectors that are not doing as poorly, while still holding on to our poorer ones and gritting our teeth all the while? Why does this make sense to you sir? It sure does not to us.
Even more importantly, why should we dilute our performance markedly by listening to you to protect against events that can be much better managed by our just paying attention? Why are we assumed to be chained to our positions here and then look to manage this big disadvantage that we have so willingly put ourselves under, which we cannot even do well?
Why are we allowed to change horses to seek and maintain diversification balance but not allowed to do anything when our horse falls to the ground? Why are we treated like children who cannot be trusted to manage their affairs sensibly and instead have to rely on broken ideas that do not even protect us when we actually need the help?
We’ll never get beyond the mindless way that we approach investing by just continuing to accept the bad ideas that the industry sells us. Choosing to bet on events such as stocks going up and refusing to pay attention to the cards being dealt along the way should be seen as an idiot’s approach to investing, if only we can manage to step back from the table enough to at least start asking why we do this.
If we really want to play this game well, and not badly, we really do need the curiosity of a child to gain enough perspective to know what good and bad play even consists of. Instead of balancing and rebalancing, can’t we just sell things that have now soured and otherwise keep them while they are good? Unless we ask such things, we’ll never get the answers we need.
It is not enough just to know what we should not be doing, we also need to know what we should be doing, although it’s not blindly using diversification as our sole strategy, which is just madness in spite of how popular the madness is.
In order to decide what we should be doing instead, we need to ask one more question, which is what we are trying to accomplish when we invest in stocks. The answer is that we want to do well, and as simple as this appears, we need to actually keep this in mind when we formulate our strategy.
Seeking to do well both involves looking to be in the right positions, to seek out the best returns we can, and also has us wanting to do well by protecting ourselves by being sensible about positions that are not going well. This is like hiring the best people you can, monitoring their performance, and replacing them when their performance becomes sub-par or when someone better becomes available.
Hiring a bunch of random people and keeping them on regardless of how they do, and even firing some of the best and replace them with lesser workers to “balance” things, just does not make any sense, but somehow with investing, we manage to create a façade of sensibility that can survive unexamined, but wilts under observation.
When diversification in itself becomes our sole goal, we end up not only setting our actual goal aside, we pretend that the goal doesn’t even exist, to the point where we are not even aware of what we are throwing away. What we don’t know will hurt us, whether we are aware or not.
We like Schwab’s idea of formulating our portfolio initially and then balancing things when required, and if all we do is replace the goal of diversification with the goal of doing well, we can use this to select good stocks and then balance things by replacing the ones that turn bad with ones that are doing well.
If our focus is on balancing for not its own sake but to enhance performance, now we’re getting it. Adulterating our portfolio with bad stocks just for the sake of variety, and insisting on holding stocks once they start to rot, will not only lower our performance, it will ironically expose us to more risk.
This need not be complicated and even a child should be able to pull this off with only a bit of training. Good stocks are bought and kept, bad stocks are thrown out, just like we do with food in our refrigerator. If the discards become worthy again, we can re-consider. Choosing inferior performing stocks just because we want different things will not protect us and just harms us on both the risk and return side.
Choosing stocks from different sectors will only really help us if these stocks can pull their own weight, and if they can’t, they don’t belong in our basket because they will serve as millstones around our neck. Our own brains need to be in charge and while it’s fine to consider the advice of others, we need to do our part as well and think about the matter, especially with so much at stake, and never just accept what we are told.
If we don’t bother asking why, we’ll never know what is good and bad and will simply be relegated to being just another brick on the investing wall. Bricks don’t know any better, but we need to.
Editor, MarketReview.com
Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.
Contact Andrew: andrew@marketreview.com
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