Rule 3: Invest Wisely (The Theory)

Early retirement requires sound investing.  Figuring out what that means can be tricky.

Let's say some guy is raising a family of four on a mere $300 a week.  And each week, he spends $50 of that $300 on lottery tickets.  Bad decision, right?  Now let's say one particular week he actually wins.  Like, $50 million kind of win.  Hmmm...good decision after all?
 

Nope.  Still bad.  Just because the outcome is great, doesn't mean the decision was sound.  Conversely, just because an outcome sucks, doesn't mean the decision was poor.  We mix up decisions and outcomes all the time.  But they are distinct.

"Cute model, Deadwood.  But how do we know we are making good decisions?"

Oh, I didn't see you there, Slash.  Welcome.  For investments, a good decision is when the potential reward (a.k.a. return) is worth the risk.  In the lottery scenario, the odds of winning are horrible.  So banking on lottery tickets is about as poor an investment decision as you can make.  You are simply taking on too much risk for the potential return.

"But I would never do that, Dogwood.  So this whole framework is irrelevant to me."

The lottery is an exaggerated example, for sure.  But how many times have you heard a friend or co-worker talk about a great investment opportunity?  A company with an enticing book-to-bill ratio.  Or a piece of a luxury vacation rental that is sure to beat stock market returns.  In all this talk, have you ever heard anyone mention the risk, much less quantify it?  I haven't.

Risk and return - you can't decouple them.  Let's look at their relationship in more detail.

The chart below shows three stock portfolios, A, B and C.  B is the worst of the three.  For the same return as A, it assumes a lot more risk.  And for the same risk as C, it gives a lot less return.  So if you had a choice of the three, you wouldn't want B.  Recalling our definition of a good decision, the reward of portfolio B isn't worth the risk, given the alternatives.

Deciding if A or C is better for you isn't as straight forward.  The answer is largely a personal one based on your specific situation and blood pressure.

"Uh huh..."

The black curve is known as the efficient frontier (EF).  It represents the best return you can expect for any given risk level out of the zillions of possible portfolios out there.  If you were constructing your own portfolio, you'd want it to sit right on this line.

The red dot on the Y-Axis is known as the "risk-free rate."  Some think of it as the money market.  Others as a T-Bill.  In any case, it's pretty much a shoe-in; for all practical purposes, you have no variance (no risk) in the rate of return.

"Is this going somewhere, Dagwood?"

I hope so.  If we draw a red tangent from that red dot to the EF, we've got what is called the Capital Allocation Line (CAL).  The CAL touches the EF right at the green dot.

 "Okay, either shoot me, or tell me that green dot is special."

Oh, it's special.  In fact, that green dot is the ultimate portfolio.

By owning a combination of the green dot portfolio and the risk free asset (the red dot), you can position yourself anywhere you want on the CAL.  And see, for any given level of risk, the CAL gives you a better return than the EF!  (Except the green dot, where the CAL and EF are equivalent.)  As you move down and to the left of the green dot, you own more and more of the risk free asset as a percent of your portfolio.  As you move up and to the right of the green dot, you are borrowing more and more at the risk free rate to invest in the green dot portfolio.

"Okay, Dillweed, that sounds great.  But just how am I supposed to construct this green dot portfolio?  It's gonna be a ton of work and my life is too hectic as it is."

Turns out, investing in the green dot is about as easy as it gets.  That green dot is called the market portfolio.  For stocks, it includes every publicly traded company in weighted proportion to its market capitalization.  You get just that when you buy an index fund.

"You just unloaded a boatload of information.  Can you summarize, please?"

Sure.  We can't control outcomes.  We can only control our decisions.  Good investment decisions must take into account both reward and risk.  Strive to maximize returns for the risk level you are willing to assume.  Or, to put it another way, minimize the risk for the level of return you seek.  The easiest way to do this is to make the market portfolio the core of your holdings.

"You call that a summary, Dorkworm??"

Okay, try this:

Buy index funds.