Agonizing Over Optimal

Stop Analysis ParalysisDo you agonize over finding the optimal asset mix for your portfolio? Have you become perplexed trying to make a decision whether to be 70% in U.S. stocks and 30% in international stocks or 67% in U.S. stocks and 33% in international?  If so, you suffer from a common investor aliment. It’s called analysis paralysis, and I have a cure.

Analysis paralysis happens when you try to create the perfect portfolio. You read books, articles and research, ponder all the data, spin it all around in your head over and over again, and ultimately cannot come to a decision. If you happen to take action, you’ll starting question this decision from the start.

There is a reason analysis paralysis occurs when you try to find the optimal portfolio. It’s because the optimal portfolio doesn’t exist.

OK, that’s not correct. The optimal portfolio does exist — just like the winning Mega Millions lottery numbers exist. We just don’t know what they are. The optimal portfolio mix only reveals itself after it has already happened, when we look back at market returns and correlations and determine the mix we should have had.

I laugh when I read asset allocation recommendations put out by big investment companies. They’ll write pages and pages on how they are fine-tuning their perfect investment mix. Here is an example, “Our optimization model now points to 31.3% in large cap U.S. stocks, up from 29.7%. We also recommend reducing small cap stocks to 13.6% from 15.2%.”

This analysis is gibberish. Several years ago, The Wall Street Journal tracked asset allocation recommendations by several large Wall Street firms. Their results were compared to a static “Robot” blend that held 55% in stocks, 35% bonds, and in 10% money market funds. Eight out of twelve firms fell below the Robot blend over the 5-year study, and this number doesn’t account for the firms that dropped out during the period. For more details, you can download a free copy of my book, Serious Money, from my website (or purchase a hardcover copy here).

Here is the cure for analysis paralysis. First, come up with a couple of portfolio choices that make sense, given your long-term goals. Second, pick one.

It doesn’t matter which choice you pick because the probability of being right is the same for both. It’s not possible to know if a 70% U.S. stock and 30% in international stock portfolio will beat a 67% U.S. stock and 33% international stock portfolio. We do know the difference in returns will be negligible. So don’t become paralyzed over the decision.

What matters in successful portfolio management is deciding upon a sensible allocation based on your needs, filling those allocations with low-cost investments such as index funds and ETFs, and then staying the course through all market conditions.  This is what makes a successful portfolio.

Recall Von Clausewitz’ epigram, “the greatest enemy of a good plan is the dream of a perfect plan.” A sound philosophy, sensible portfolio strategy and solid discipline are the keys to investment success.