Chapter One

I Know Your World

As I said in the Introduction, I have been a financial advisor since 1987. I saw the Dow Jones Industrial Average fell 22.6 percent in a single day. This decrease remains the index’s largest single-day drop on record. What isn’t mentioned often in this statement is that the Dow recovered to a positive annual return by year’s end. During the three-plus decades since, I have witnessed six “bear markets” (when the market drops over 30 percent in one short period). During each of these crises, I have had progressively fewer clients panic. If memory serves me correctly, no client bailed out of the market in 2020. My goal is to give you techniques allowing similar outcomes with your clients.

During my entire career, I have been a bit of a continuing education junkie, getting a handful of advanced credentials that have formed my opinions about how to manage clients’ money. In the following pages, I will share what I have learned with you. I invite you to spend a weekend reading the book. Please write in the margins, highlight as you wish, and provide me with any feedback that you feel led to give me.

I’ll begin with a few observations.

The limits to Modern Portfolio Theory

Dr. Harry Markowitz earned a Nobel Prize for describing how you can diversify your assets to achieve lower risk while getting higher returns using a variety of assets with different performance cycles. The mathematical language describing this performance cycle diversity is correlation and covariance, and any finance professional must acknowledge that these issues matter. In basic parlance, this means that the investor should spread their assets across multiple asset classes, especially those whose performance cycles vary: when one zigs, the other one zags.This does, in fact, smooth our year-over-year performance. It is important for financial planning. It is never perfect, but it does tend to make future asset growth rates more predictable.1

Now, stop right there. In the modern world, this concept is taken much, much too far. We want investments that zig and zag considerably from one another, not slightly, but close to 100 percent. Stocks and bonds. Bonds and real estate. Cash and venture capital. You get the idea.

Using Modern Portfolio Theory to justify investing in only slightly non-correlating assets is a waste of time and money. The most important example of this is the correlation between the Standard and Poors’ 500, better known as the S&P500, and the Europe, Asia, and Far East Index, better known as the EAFE index. We both know that for your entire career and mine, the traditional financial planning community has pushed you to have international diversification, yet that all-import metric, colloquially described as “when one zigs the other zags,” or correlation shows that this is false diversification.

When one asset’s performance is completely countercyclical to another’s, it is said to have a correlation of -1. Naturally, when the correlation is tight, the correla