This past week reminded me of the dangers of overoptimizing.
If you’re a member of our flagship newsletter, Green Zone Fortunes, you might remember I was traveling in New York with my family last week.
The kids loved it, and we had a blast…
Until the flight home.
Flight Home Horror Story
I bought the return flight tickets in a hurry and failed to notice that I booked with JetBlue rather than American Airlines.
Rookie mistake.
But how bad could it be?
Well, our 8:30 p.m. flight was delayed to 8:50 … then to 9:30 … then 10:30.
Sometime around midnight, it was canceled altogether.
At this point, my poor children are passed out asleep on the cold, hard airport floor, while my South American wife threatened the gate agent in a way that would make a Colombian cartel boss blush.
If you’re unfamiliar, I’m always one to hedge my bets.
As I waited for our luggage, I booked another flight with American Airlines for the next morning.
We had to camp out in the airport lobby until it opened, but at least we had a plan in place.
JetBlue on the other hand couldn’t find a replacement flight for more than 48 hours.
That brings us back to overoptimization.
Running an airline is complex.
Infinite variables create ripple effects throughout the process. JetBlue is a train wreck of an airline because there is no slack in the system. If one little thing goes wrong — a pilot calls in sick, a plane is delayed due to weather, etc. — the whole thing falls apart.
And it’s not just airlines.
The same holds true in the stock market.
What My Travels Reminded Me About Optimized Portfolios
If you’re reading this, there’s a good chance you’re a “do it yourselfer” who manages your own investments.
Maybe you’ve come across portfolio optimizers that help you construct portfolios meant to help you get the highest possible return per unit of risk or the lowest possible risk per unit of return.
Now, I’m not against quant models like these.
They can be great tools, and I use them often when thinking about new investment ideas.
The problem comes when they give you a false sense of security that encourages you to take more risk than you should.
When Optimized Portfolios Fail
Ray Dalio, founder of the hedge fund Bridgewater, is one of the smartest men in finance.
In his quest to build the perfect portfolio, he found that combining a large leveraged-bond portfolio with a smaller stock portfolio gave better risk-adjusted results.
Then the COVID crash of March 2020 happened. Dalio’s perfect portfolio lost 20% in a quarter due to the leveraged-bond portfolio taking outsized losses.
The losses were recoverable, of course. But that’s still a 20% loss over three months in an optimized portfolio.
Another example, consider Long-Term Capital Management: The legendary hedge fund of the 1990s was run by the Nobel Prize winners who wrote the textbooks I read while studying for my master’s degree.
The professors’ optimized portfolio blew up in spectacular fashion in 1998 and almost took down the entire financial system with it.
They were overconfident with their optimized models. When things didn’t go as planned, they had no margin for error.
Let’s contrast this with the Oracle of Omaha.
Warren Buffett’s Must-Have Accessory
There’s a reason why Buffett is still investing over the age of 90 and hasn’t experienced a massive portfolio collapse yet.
He focuses on that all-important margin of safety. He only considers assets with minimal downside risk.
To use a colorful Buffett analogy, he wears a belt and suspenders.
A lot can go wrong in a Buffett trade before it puts him at risk of serious loss.
There’s only one Warren Buffett.
You and I aren’t him.
But that’s OK.
We can take a page from his playbook by having strong risk management in place for every trade. That’s an optimized portfolio I can get behind.
Bottom line: We talk a lot about risk management here on Money & Markets. It’s crucial — and not just when stocks head lower.
And Adam O’Dell and myself take it to another level in Green Zone Fortunes.
Every time we recommend entering a position, we have a game plan in place for when we take profits … and for when we minimize our losses when things don’t go as planned.
That’s the secret to our longevity … and why we plan on doing this until we’re Buffett’s age!
Risk management strategies are just one benefit of joining us in Green Zone Fortunes.
You’ll also gain access to a model portfolio full of stocks within today’s biggest mega trends, weekly updates from myself and Adam and bonus resources that help you make the most of our Stock Power Ratings system. We want to help you make money — no matter the market!
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To safe profits,
Charles Sizemore, Co-Editor, Green Zone Fortunes
Charles Sizemore is the co-editor of Green Zone Fortunes and specializes in income and retirement topics. He is also a frequent guest on CNBC, Bloomberg and Fox Business.