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18 February 2024

Chutzpah


By Adrian Colarusso, CFA, CFP®

February 18, 2024

Last week I caught up with a friend in Israel who had questions about her startup options compensation package.

Company leadership was tweaking their equity awards, causing nuanced tax and risk implications for employees. Although there was no “right” answer to her question of “what should I do?”, we accomplished two things:

  1. We outlined the trade-offs between minimizing taxes and risk – i.e., if you are confident in the upside and want to lower future potential taxes, do this; if you fear the risk of lighting money on fire, do that.
  2. We recognized the decision wasn’t binary. In the face of uncertainty, the answer is usually diversification. Do a little of this and a little of that. The goal is to protect yourself from regret in multiple future states of the world.

Her decision boiled down to calibrating chutzpah.

This is also a core tenet of all wealth planning, including how we manage investment portfolios, which we’ll dive into below.

The right amount of chutzpah

The Yiddish word can mean “gall, nerve or audacity”. Or it can evoke the more charitable “gumption, fearlessness and self-confidence”.

We’ve met people whose lack of chutzpah is holding back wealth creation, and others for whom excessive chutzpah – intended and unintended – is putting wealth in jeopardy.

Hiding out in cash when they should be investing, paying off low-interest mortgages early, and overstaying their time in a comfortable job instead of seizing a new opportunity are common examples we’ve seen of folks lacking chutzpah.

As for those with misplaced chutzpah, some hold investment portfolios overloaded in specific stocks, cryptocurrencies, or sectors of the market. Others are overconfident in risky entrepreneurial pursuits and job opportunities.

Those with well-calibrated chutzpah take risks that are deliberate, diversified, and appropriately sized. They invest in portfolios that are matched to their unique situations, without biases rooted in fear or greed.

Active risk as a measure of chutzpah

Here’s an investment portfolio we came across recently. How do we know if it’s sensible, audacious, or chicken-hearted?

The first step in our investment process is to benchmark. This portfolio consists of mostly large US companies. A sensible comparison is the S&P 500 Index.

We analyze portfolios risk-first. It’s difficult to forecast returns, and past performance can easily mislead us. It’s easier to extract insights from risk measurements if you have the right tools.

Before even doing any risk analysis, we can make some quick observations. This portfolio consists of 16 companies, compared to the S&P 500’s… 500. The largest portfolio holding is Lockheed Martin at over 17% – compared to 0.23% of the S&P 500 Index. In contrast, the largest company in the index is Microsoft at 7.24%. So, this portfolio is overweight LMT by 17% and underweight Microsoft by 7.24%. These are large bets on just two companies. Note that the absence of a stock is a bet, too!

Below is an output from a tool we use, which I helped develop during my time at BlackRock. It estimates the forward-looking volatility of the stock portfolio versus the S&P 500 index:

Exhibit One: The portfolio exhibits higher estimated risk than benchmark

Source: Aladdin by BlackRock. Neither BlackRock nor the Aladdin portfolio risk model can predict a portfolio’s risk of loss due to, among other things, changing market conditions or other unanticipated circumstances. The Aladdin portfolio risk model is based purely on assumptions using available data and any of its predictions are subject to change.

We see that the expected standard deviation – one measure of risk – is almost five percentage points higher than the index’s, or 25% riskier. Higher risk isn’t necessarily good or bad, but it should fit intentionally with the investor’s wealth plan.

We can also measure the differences in risks between the portfolio and the benchmark – known as “active risk”. This gives us an idea how much we’d expect the portfolio’s returns to deviate from the benchmark’s in a given year based on differences in individual exposures.

This portfolio shows an active risk of 8.5% against the S&P 500 Index. This implies that the portfolio could easily underperform or outperform the S&P 500 in a given year by 8.5%.

Exhibit Two: You got alotta chutzpah diverging that far from the S&P 500!

So, if the S&P 500 returns 10% (near its long-term average), it’s a crap shoot where this portfolio’s returns will come in. It easily could be as low as 1.5% or as high as 18.5%, landing in those bounds with about 67% probability, or a one standard deviation confidence interval. Underperformance by even half this active risk level over a handful of years can compound into meaningful wealth impairment.

Conventional wisdom and reams of research suggest how difficult it is even for professional investors to beat the S&P 500 Index. Stock specific risk is easily diversified and is inherently not well-compensated, unlike the pure and simple “equity market beta” that dominates the index, which has more consistently rewarded investors over time.

We focus on risk-adjusted returns, and not returns-at-all-costs, and tend to run portfolios at or slightly below benchmark risk, with more modest levels of active risk. This portfolio would have to outperform the benchmark by a lot to justify the added volatility, and the insights must be supremely well-developed to justify that much active risk.

In conclusion, this portfolio has a lot of chutzpah embedded in it. It may perform just fine, but it also may produce results that are wildly out of alignment with a more risk-aware strategy.

Let’s look at your portfolio

Investors can achieve similar success with different approaches. There is no single “right way” to construct a sensible investment portfolio.

If you are managing your own portfolio of individual stocks or ETFs and mutual funds, we can run an analysis and share our findings. We promise to respect your view of the world and not to impose our own too much. Don’t feel like a burden; this is genuinely fun for us and comes with no strings attached.

If you want, we’ll zoom out to broader benchmarks, not only the investible ones but those that matter for your long-term goals. We can help you invest in the context of your unique wealth picture and suggest areas for improvement on risk, return potential, diversification, taxes, legacy planning, and more.

Please schedule time to chat here and consider sharing this newsletter with your friends!

*All S&P 500 Index weights are as of 2/13/24, sourced from ishares.com/IVV.