Over the past half century, the financial industry has coalesced around one yardstick to measure success—risk adjusted returns, or the amount of return earned per unit of risk taken.
There’s another, simpler method of measuring success that will be more meaningful to most investors, according to Ashvin Chhabra, President and Chief Investment Officer of Euclidean Capital– a New York based family office for James H. Simons & Marilyn H. Simons.
“Ask yourself what the purpose of the money is you’re investing, what is the purpose of the investment,” Chhabra said on a recent Standard Deviations podcast hosted by Dr. Daniel Crosby, Chief Behavioral Officer at Orion Advisor Services. “If you achieved it, you were successful. If you did not, you were not.”
A Better Measure
Measuring success in investing in terms of the performance of financial markets has very little to do with real life, said Chhabra. Real people have goals, and some of those goals are essential to achieve, while other goals are more aspirational.
At a most basic level, success is being able to achieve one’s essential goals, said Chhabra.
“In other words, if you want your kids to go to college, you want to make sure they can go to college irrespective of what the S&P 500 does that year or in that decade,” he said. “Then, equally important, is the other side of the coin, which are what I call aspirational goals. These are the things we want to do, that give us meaning in life. These are the intersections of our passions, our expertise and what we spend our time on—there I would say the purpose of investing, the purpose of money is to give us a chance to pursue these things, to live the life we would like to lead.”
Failure to address aspirational goals in a financial plan leads to regret, said Chhabra.
Where Diversification Fails
At the core of Chhabra’s beliefs on risk and return is Harry Markowitz’s Modern Portfolio Theory, that argues most people are best served by a portfolio of traditional asset classes that balances risk and return through diversification.
A traditional diversified portfolio is ill-suited to satisfy investors, according to Chhabra, who claims it will always disappoint investors along one of two dimensions.
One is the assumption that diversification means safety—while diversification addresses volatility risk, finding the best risk-return tradeoff for investors, financial markets are by no means absolutely stable over the length of a lifetime. Financial markets can break down—while they usually recover, sometimes they take a long time to recover. Occasionally markets go out of existence altogether.
“A diversified portfolio does not give you safety at all times, it just gives you safety in the long run and on average,” said Chhabra. “That’s one dimension where you’re guaranteed to be disappointed with a market portfolio.”
But just as the diversified portfolio is designed to maximize return per unit of volatility risk, it also fails to address the aspirational drive of most investors. Investors are unlikely to get big wins from market investing, they’re unlikely to exceed their peer group and they have little chance to increase their station in life from investing alone.
Wealth Allocation Framework
To address this shortcoming, Chhabra has proposed a wealth allocation framework based off of three buckets: Safety, Market and Aspiration.
Safety is just as it sounds, a bucket that isn’t intended to generate any real return. Investments in the safety bucket may include cash, insurance, gold, certain types of short-term bonds and certain other real assets likely to retain their value over time.
Aspiration might have investments intended to achieve a 10x or 100x return, but when Chhabra thinks of the aspirational portfolio, he’s primarily thinking of investments in accordance with one’s talent, knowledge or wisdom, including investments in oneself.
“You might almost say ‘what happened to Markowitz?’ and the beauty is that Markowitz is right in the center because that is the most efficient way of extracting return from the markets,” he said. “In the middle bucket you have a diversified portfolio, it will give you a nice, healthy way to retirement over the long term. When the market goes up, it will go up, and when the market goes down, it will go down. Don’t panic, that’s return in the long term.”
This aspirational portfolio, a term that Chhabra coined in 2005, is a concept based on how wealth creation takes place: be better than everyone else at something, do that thing continuously, and do it until it becomes a larger and larger part of your portfolio.
Assets should be balanced between safety, market and aspirational, said Chhabra, rather than asset classes or time horizons.
“The idea is that different parts of the portfolio have different objectives, and some will do better or worse under different conditions but coming together it should work well in terms of many scenarios and many different constraints,” he said. “Take seriously the idea that crashes will happen often, and they create both terror and bad consequences but also opportunities to rebalance and add on… Great technology companies are born during these crashes because in many ways talent is easier to acquire as opposed to during a frenzy where everything is overvalued.”
Rather than blunt the impact of volatility with an asset allocation to bonds, handle volatility by constructing a multidisciplinary safety net in the safety side of the portfolio that might also be able to serve as a type of “bond runway” to create income over time.
Behavioral bucketing puts the investor at the center of the wealth allocation framework instead of a return versus market indexes.
“Investing is really about you and your aspirations, one of the most important assets you have is your human capital and that human capital over your lifetime will grow from potential to earning power to creating assets for you, and if you work on that ever day rather than worrying about what you can’t control…” said Chhabra. “Right? You can control yourself, you can’t control the markets. Over time, your human capital can compound and serve as both a safety net and a wealth creation engine.”
