So, Big ERN drops this post the other day and my phone immediately lights up. Three different guys send it to me within minutes of each other.
And honestly? This is exactly why I write this blog. This is the mechanism working as intended.
Agustin Lebron has this great line: “Betting is a tax on bullsh*t.” I think there are actually three layers to that, and placing the bet is only the final step.
1. The Public Journal First, you write it down. You don’t just write to broadcast; you write to understand. Putting it in public forces a level of accountability you just can’t get in a private diary. It stops you from lying to yourself.
2. The Stress Test You bounce your convictions off people you respect, people who are smarter than you and who you trust to tell you the truth. You let them take a bat to your ideas and see if the thesis still stands when the dust settles.
3. The Skin in the Game Only then do you put your money where your mouth is.
I saw another financial creator the other day asking why he should bother showing his actual portfolio to his audience.
Are you kidding me? That is the point.
Are you putting out academic theories, or is your actual net worth riding on these ideas? It is infinitely easier to be a genius with a paper portfolio. Backtests don’t have emotions. Spreadsheets don’t have panic attacks at 2:00 a.m. Doing it with real money changes the chemical equation. It is as simple as that.
In fact, it scares the hell out of me when people email me saying, “Hey, I love this capital efficiency stuff, I’m going to adopt it in my portfolio.”
My stomach drops. My brain goes, “Wait, do you actually understand all the implications of this?” And then the paranoia sets in: “Wait, do I even understand all the implications?”
Lebron also says that as a trader, you are never happy with the amount you traded. If the trade rips, you’re mad you didn’t buy more. If it pukes, your size should have been zero.
The same applies to diversification. I have assets in my portfolio right now that are dog sht. They’ve been dog sht for years. That’s the game.
“Am I wrong?” “Oh my god, now all these other guys are in the same trade.”
I ask myself these questions every single day.
And that brings me back to the Early Retirement Now post. I read it, and I had to roll my eyes. Look, there are plenty of valid concerns you could raise about diversification. Real risks.
But these? These are the concerns you pick?
Let’s have some fun and look at them one by one.
Lie 1
I have to say, on this specific point? I am with him 100%.
I can’t tell you how many times this exact scenario has played out. I’m explaining the components of NTSG, specifically the equity part, and I mention that it is essentially ACWI (All Country World Index).
Without fail, someone pipes up: “Well, not really. And unfortunately, what I like most is ACWI IMI.”
And every single time, my brain goes straight to that scene from The Office. You know the one. Corporate needs you to find the differences between this picture and this picture.
When you are following a market-cap-weighted index, small companies have small impacts by definition. That is how the math works. If Apple sneezes, it moves the needle more than the bottom 2,000 companies combined.
Who cares if you are missing the micro-caps? It’s noise. It’s a rounding error.
And honestly? If you look at the data, just like ERN points out, it looks like you might actually be better off without them anyway. So why are we majoring in the minors?
from here
It feels like when my wife asks me to buy her a flat white with matcha and oat milk. You know what? Sometimes, if you want a coffee, just take a bloody coffee.
Lie 2
I saw this picture he put up, and for a split second, I thought “Okay, here we go. He’s finally going to talk about the real risks of diversification, the stuff that actually matters.” But no. We are back at small caps again.
Now, let’s talk about the analysis itself, specifically that look back at the last 10 years.
Ten years doesn’t tell you anything about an asset class, it’s a classic case of data mining to support a pre-determined conclusion.
Why would he do this? He’s a quant. He knows better than anyone that you need at least three decades of data to draw any meaningful conclusions about whether a factor premium is dead or just taking a nap.
It’s weak and beneath him. It’s the equivalent of looking at the S&P 500’s performance from 2000 to 2009 and declaring stocks are a bad investment.
I see this graph and my reaction is the opposite of his: “my analysis about SC might be wrong then!”.
If adding SC exposure only marginally dings your risk-adjusted returns (see above), you take that bet every single time. Why? Because ERN is ignoring the biggest variable in factor investing: the premium can come back.
It’s a contrarian thesis. The more time people like him spend writing detailed takedowns explaining why the Small Cap premium is dead and buried, the higher the probability that the damn thing is about to resurface. The crowd is moving away, liquidity is drying up, and that’s where the opportunity is eventually born.
If I had to pay a significant price (a big drop in Sharpe Ratio, huge fees, etc.) for this SC bet, then it wouldn’t make sense. But what he’s showing is a practically free option. It costs almost nothing in terms of performance drag, but it gives me upside exposure to a potential reversion to the mean. Why in God’s name would I not take a free option? The same logic applies to other factors, too, as long as the exposure is basically free.
(In past blog posts, I expressed my idea on why the Small Cap premium might be an anomaly of the past, if ever there was a premium on a risk-adjusted basis, considering all costs)
The cost, for a guy like me trying to run a capital-efficient portfolio, is that there is currently no suitable, cheap instrument to add meaningful small caps to the stack.
I remember years ago, back when the Picture Perfect Portfolios guy was blogging, we looked at USML, the 2x leveraged US Minimum Volatility ETF. Now, Min Vol is a great factor and it’s perfect for a capital-efficient framework.
But USML’s expense ratio? It’s too damn high. It eats the alpha. You can’t justify layering that kind of drag onto a strategy built on efficient use of capital.
So, the issue isn’t the theory of small caps. The issue is that the available, leveraged, factor-tilted ETFs are too expensive or don’t exist for the specific exposure I want.
The diversification benefit you get from other asset classes is too high and efficient compared to these alternatives.
But I agree with ERN, you should not embed any past Small Cap premium to your future SWR expectations, though.
Lie 3
Considering the meme at Lie #2, this is even sillier: I guess he knows asset classes with low to negative correlation to stocks exist? Why the range of examples he uses is just 0.7, 0.8 and 0.9?!?!
This is how he should have done it. If you want to better understand the relationships between correlations and volatility, read it because it is written really well.
Lie 4
See Lie #3. Maybe…try with different asset classes?
Lie 5
Let’s talk about that headline he chose, that’s the lie. Nobody who runs a (really) diversified portfolio is saying, “I don’t care about returns.” That’s a straw man argument.
In fact, the opposite is true: Risk Parity (for example) uses leverage EXACTLY because it recognizes that the raw, unleveraged expected returns might otherwise be too low to hit the required targets.
This isn’t some academic exercise in minimizing risk at all costs. It’s a fundamental trade-off, and when diversification is done correctly, it’s a good one:
- Diversify for Efficiency: You use genuinely uncorrelated assets to increase your risk-adjusted returns (Sharpe Ratio). This improves your Sustainable Withdrawal Rates, which is the ultimate goal of the ERN crowd anyway.
- Leverage for Target Return: Once you’ve squeezed all the (unpaid) volatility out of the portfolio, you then use leverage to scale that efficient portfolio back up to your desired level of expected absolute return (or volatility target).
The whole point is not to strip returns down to the bone. If you remove all risk, you’re left with the risk-free rate. That’s a CD, not a portfolio.
But I do not want to pass the message that leverage is necessary. ERN analysed the Golden Butterfly and…the analysis was pretty lousy (to mention one thing, he assumed an investor would still allocate to gold when gold was “cash under the mattress” during the standard), therefore his conclusion. Any portfolio idea flirts with data mining, but I would rather bet my future on more diversification rather than less. We are trying to optimise left tail scenarios, remember?
Granted, I would not rush to call anyone following the ERN target portfolio a fool (also because the raw odds suggest I will live in a period when that strategy thrives).
Lie 6
Look, ERN’s 100% stocks argument sounds great until you actually try to live your life with it.
Here’s the thing nobody wants to talk about: even during the accumulation phase, life happens. You think you’re building this beautiful retirement portfolio, and then boom, you need cash. Maybe it’s a health thing. Maybe it’s an opportunity. Maybe your kid needs help. Whatever. The point is, sequence of returns risk isn’t just for retirees. It’s for anyone who might need to tap their portfolio before some arbitrary finish line.
And before you come at me with “well, I’ve got my emergency fund and my buckets/pyramid steps/sleeves”: congratulations, you just proved my point! You DON’T have a 100% stock portfolio. You’ve admitted that holding some non-equity assets actually matters. We can end the debate right there.
But here’s the deeper issue that gets glossed over: when you’re planning for retirement, you shouldn’t be optimizing for the highest average return. You should be optimizing for the best odds of actually getting there with enough money. That’s terminal wealth, not average wealth. There’s a difference, and it matters.
Lower volatility can actually produce higher compound returns over time when you factor in behavioral reality AND the math of recovering from drawdowns. Yeah, yeah, I know: that requires some sophistication and maybe you don’t want to spend your weekends becoming a portfolio construction nerd. Fine. Take a small hit to your expected CAGR and sleep better at night.
But if you’re the type who’s read every word of ERN’s Safe Withdrawal Rate series? You might already be there 😉
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