Does the Perfect Portfolio Exist?

IN 1999 I was a know-nothing college student studying finance at Georgetown University. The internet was the hot new thing, and I’d just purchased a computer that was the size of a small refrigerator. Despite my ignorance of investing, I had a profound curiosity and a voracious appetite to understand the world of money.

It was during this time that I destroyed my very first investing relationship. Luckily it was only a simulation. I was taking a course on derivatives, and we’d spent a significant amount of time studying some of the most famous fund implosions in investing history, which often included leverage and derivatives. Ironically, having studied the dangers of these strategies, the course included a simulation during the quarter in which I managed to turn $100,000 into $100 by actively day trading soybeans and lean hog futures. I didn’t even know what a soybean was at the time, but that didn’t stop me from incinerating the value of them within my portfolio as I impatiently day traded with leverage. I’ll never forget the note from my professor, in big bold red letters, about the performance: “WOW.”

When I stopped day trading futures in 1999, I began obsessively reading Warren Buffett’s shareholder letters. I had learned that decimating soybean futures wasn’t for me, and I evolved into a “value investor.” I was getting wiser but starting from a low bar.

I began pouring my weekly earnings from waiting tables into a stock called Sirius Satellite Radio and a handful of other techie names that appeared, to me, to fit the value investing criteria. Sirius had fallen 75% from its peak and, based on my amateurish analysis, was a good value and had bright prospects. I had never really considered that a stock that is down 75% can fall another 75%. And it did. I was crushed as I watched my beer-drinking money go up in smoke. I can’t be sure if it was youth, ignorance, or a bit of both, but I had not learned the art of patience at this point in my life.

In retrospect, I had also failed to understand one of the most important trends in the market – the macro trend. I had no idea at the time, but we weren’t just in a bear market at this point in history – we were undergoing a seismic macro market event that was devastating everything in its path. The implosion of the Nasdaq bubble welcomed me into the world of investing like a punch in the face, and as Mike Tyson famously quipped, I did not have a plan to deal with it.

As I dusted myself off from the dot-com bust, I started to find my footing. I had landed a job out of college working at Merrill Lynch and our team was managing hundreds of millions of dollars for retail investors. My boss was a brilliant old-school stock and bond picker, and I had the good fortune of learning from some of our best research analysts in the firm. I was learning fast, but my impatience again got the best of me, and I determined that the high-fee sales commission world wasn’t for me. I left the firm, struck out on my own, and lucked into managing an event-driven strategy that focused on trading illiquid stocks and futures contracts in the overnight market. This turned out to be what we now know as the “overnight effect” – the fact that stocks generate much of their excess return when the market is closed. Over a five-year period, I generated 20.75% annual returns (15% net of fees), while the S&P 500 remained flat. I felt like a genius for a brief period, but this strategy also got side-swiped by a macro trend – what we now know as the Great Financial Crisis (GFC). I was fortunate to generate a 15% return in 2008, but as all markets froze in 2008 and 2009 I found myself seeking a more stable and structured process that didn’t entail 100-hour weeks and waking up at 3 a.m. to flip stocks.

Although I wasn’t even 30 years old at this point, I’d cycled through dozens of investment strategies already. I was like a speed-dating junkie unable to remain committed for more than a few years.

The GFC was formational for me and illustrated the importance of having a more robust, long-term and all-weather style of portfolio. I soaked up everything I could learn about macroeconomics and macro investing, and pivoted again, this time towards more sustainable financial planning-oriented strategies grounded in what I like to think of as a first principles approach to portfolio construction. I wrote a paper in 2011 called “Understanding the Modern Monetary System,” which quickly jumped to being one of the most read papers in the SSRN research database for a decade. Like me, investors emerged from the GFC hungry for a more grounded and operationally sound understanding of money and investing.

During this period, I tirelessly studied the top portfolio strategies from the world’s best investors, all in pursuit of the perfect portfolio. Over the course of the last 20 years, I’ve had the good fortune of getting to know some of the greatest investors in the world. And I’ve helped oversee billions of dollars and helped thousands of investors achieve financial independence putting all these lessons to work. Over this time, I’ve realized that portfolio management is like dieting – we’re all on an endless search for our six pack that too often ends up with us on the sofa with a plateful of chocolate brownies. Good portfolio management is a delicate balance of behavioral control and risk optimization. And like any sustainable diet, it must be customized to your personal needs and wants.

If you’re like me, you’ve tried a million different fad diets and workout regimes. In theory, being healthy is easy – eat right and exercise. But in practice it can be difficult thanks primarily to the existence of snacks and sofas. Dieting is especially troublesome because it’s difficult to remain loyal to a single diet. But what if you could find the Holy Grail of dieting: a diet you enjoyed that helped you stay healthy? How much easier would your life be and how much better would you feel?

In 2015 and 2018, researchers published papers about the efficacy of different fad diets.¹ You probably know most of them – I certainly do because I’ve tried and failed all of them at one point or another.

The interesting conclusion from their research was that there is no Holy Grail of dieting for all people. In fact, what they found was that the only diet that worked was the one you stayed faithful to. In other words, all the diets work if you find the one you can stick with.

Portfolio management is not so different. You don’t need to find the perfect portfolio for all people at all times. You need to find the portfolio that’s perfect for you and then you need to remain loyal to it long enough for it to work for you.

There’s a perfect portfolio out there waiting for you to find it. You’ll have to test the waters and see what works for you. More importantly, your portfolio might have to evolve over time. The financial markets and the economy are constantly evolving and adapting. Your portfolio will have to adapt and evolve too, not only to account for the changes in the world, but also for the changes in your life.

What works for one person is unlikely to work for all people. That is, after all, what makes markets work. People have different goals and different needs. So don’t settle for the portfolio that someone else uses (or promotes) just because it works for them. You’ll need to search out and test different portfolios to help you find the one that works best for you. It’s out there. You just need to keep looking.

I hope that this book will be a testing ground for you to learn and understand different portfolios so you can begin to narrow down this search for yourself. At best, I hope this book will help you find a portfolio you can fall in love with while avoiding some of the expensive divorces I encountered along the way. At worst, I hope reading this book helps you learn a few useful concepts. I am here to help as best as possible. I have my own preferences and biases in this process so don’t treat my word as gospel. Treat this book as an open-ended exploration of different concepts and not a bible of conclusions.

That said, this is probably a good time for me to note that if you have questions or positive feedback please email me at cullenroche@disciplinefunds.com. If you have hate mail please contact the current head of the Federal Reserve at chairperson@federalreserve.gov. They had nothing to do with writing this book, but the Fed Chair is always a logical scapegoat for anything that goes wrong in the world of finance.

Alright, let’s get going.