In the world of finance, we are largely taught to worship at the altar of the Law of Large Numbers. The theory is simple: over a long enough time horizon, your investment outcomes will eventually converge toward the historical average.
But there’s a problem. You aren’t an “average.” You aren’t a thousand investors playing out a thousand different lives. You are one person, with one life, and a very specific set of cash flow needs.
This is what we call ergodicity. In Excel, a 7% average return looks like a straight line. In the real world, if you hit a -30% drawdown right when you need to pay for your kid’s wedding, the “long-term average” doesn’t matter. You’ve already lost the game.
Most people try to solve this with a traditional Strategic Asset Allocation (SAA), the classic “60/40” approach. But the classic SAA framework is starting to show its age: thank you, inflation. Well, at least that’s the story for the masses. After the massive rally in gold (forget about the last few days), I saw the 60/40 turning into a more common 60/30/10, but that’s not really a game-changer.
There is a new methodology in town and it is called Total Portfolio Approach (TPA).
Here is why your current framework might be failing you, and how to fix it.
Risk Factors vs. Asset Classes
Traditional SAA treats asset classes like separate islands. You have your “Stock” bucket and your “Bond” bucket. But looking at the world this way is like trying to describe a meal by only looking at the colors of the food.
The TPA framework uses a shared risk language. Instead of looking at the wrapper (the asset class), we look at the ingredients (the risk factors).
Consider these five core factors:
- Equity
- Interest Rates
- Liquidity
- Commodities
- Credit
In a classic model, bonds and stocks are seen as separate entities. But in reality, they overlap. Value stocks have different interest rate sensitivities than Growth stocks. If you own both Long-Term Treasuries and high-growth Tech stocks, you might think you’re diversified, but both are getting hammered by the same interest rate factor. The size of that overlap depends entirely on what’s inside the buckets, not the labels on the outside.
The Incentive Problem at Institutional Level: Managers vs. Portfolios
This “bucket” thinking doesn’t just cloud your vision; it creates bad behaviour.
When you separate “growth” assets from “defensive” assets (like long volatility or trend following), you highlight the “bleed” of the defensive sleeve without appreciating its contribution to the whole. At the institutional level, this is toxic. A manager responsible for a defensive sleeve feels like they are in a losing competition with the S&P 500.
To survive, many trend-following managers have started adding carry strategies to their mandates. They aren’t doing this to improve your total portfolio; they’re doing it to make their individual fund look less “bad” during bull markets.
By chasing better relative performance, they lower the diversification benefit they were hired to provide in the first place. It’s like removing the seat belts from your car to reduce weight and go faster. You look better on the leaderboard right up until the moment you actually need the protection.
The Competition for Capital
TPA formalises another aspect that we discuss a lot in this blog. We refer to it more often as capital efficiency: we have a scarce resource, our portfolio has to sum to 100%, and we want to allocate capital in the best possible way.
Every time you add a new investment, you are firing another one. This “Competition for Capital” means that an asset shouldn’t be judged solely on its own merits, its idiosyncratic performance, but on how it plays with others.
We can’t simply rank investments by their expected returns. In the TPA framework, we prioritize the interrelationship of risks:
- Correlation matters almost as much as nominal returns.
- A high-volatility asset that moves opposite to other risk factors is often more valuable than a low-volatility asset that moves in lockstep with them.
Even if you don’t have a complex model running in the background, you must operate within this mindset. Every dollar is a soldier; you need to deploy it where it provides the most marginal benefit to the entire army, not just its own squad.
The Goal-Based Trap
Traditional “goal-based” investing sounds great in a brochure, but it usually falls apart when life gets messy. Its biggest flaw? It can’t handle trade-offs between objectives. Cannot quantify them.
The problem with pairing every goal with its own dedicated portfolio is that it forces you into a binary reality. You either hit the goal (a 1) or you don’t (a 0). And since you do not want to miss on your goals, parcelling your savings this way creates a layer of caution on top of caution. But your life isn’t a series of discrete 1s and 0s. And wealth either. In the real world, our goals are a continuous, overlapping “mash” of priorities.
This flaw is only made worse by the “tunnel vision” of traditional asset labels. When we decide that stocks are for growth and bonds are for safety, we ignore how these assets actually behave. By forcing assets into these narrow roles, we miss the opportunity to see how a volatile asset can actually provide more stability to the total portfolio when it’s negatively correlated with everything else you own.
Why “Safe” Assets Can Be Dangerous
For fifty years, the “Stocks for Growth, Bonds for Stability” mantra worked perfectly. Why? Because inflation was low and stable.
But bonds aren’t magic. They are only “stable” when inflation isn’t eating them alive. We often confuse “low volatility” with “safety.” There is nothing wrong with bonds: they always acted this way. We simply lived in a scenario that was benign to bonds.
Intuitively, we should not expect extra real returns for no risk. But…insert whatever reasons you prefer, from Boomers ruining everyone else’s lives to conspiracy theories…in that period, everyone was comfortable with the notion that we could get it.
In a high inflation environment, hopefully coupled with high risk-free rates (i.e. no high debt monetisation), I bet lads would start to think that ‘cash’ investments would be a great portfolio stabiliser. I mean, look at those high (compared to the recent past) rates and liquidity and no volatility and…potentially even higher rates if the Central Bank goes that way. Such a perfect world!!! Except…in real terms you are, if lucky, just matching inflation.
This scenario is even more penalising than the bond one we just lived through, because there is no real premium in those yields, so good luck matching your future liabilities. I remember stories from Italy before the Euro. Everyone was thrilled to see double-digit returns on their Italian Treasury Bills. They felt rich. But high inflation hollowed out their purchasing power from the inside. They were happy and losing in real terms. If you flee to “cash” today because it yields 5%, you might feel safe because the number in your bank account isn’t going down. But if inflation is also 5%, you are simply running on a treadmill, putting in all the effort and going nowhere.
A Better Way: The Multi-Goal Optimizer
Let’s take the standard advice for retirement, the glide path. You start with 100% stocks, then as you get closer to the date, the advisor tells you to move into bonds to avoid sequence of return risk. In reality. the glide path lets you avoid one risk, a stock market crash, while jumping into another, an inflation shock.
The TPA views risks in a holistic way and allows you to rank and weight competing desires. For example, you can express your priorities this way:
- Priority A: Achieving a 4% Safe Withdrawal Rate (SWR).
- Priority B: Pay Harvard for my son.
Instead of having a “college fund” and a “retirement fund” in silos, TPA views them as different points on a single timeline of cash-flow needs. The TPA allows the planner to use “stochastic risk scenarios” to see how a single portfolio behaves across both the medium horizon (University) and the long term one (Retirement). TPA ensures that a win in one area doesn’t create an unhedged risk in the other.
More assets, more risk factors and a strip of cash flows on different horizons, all in one place. This way, you can see how a shift in the portfolio, or a change in inputs like the inflation rate, can affect the probability of success of all the goals. A shift in the investment strategy might lower the probability of success on Priority B to 90%, an acceptable level for you, while increasing your terminal wealth by 30%. Go figure that out with your goal-based framework.
More relevant, go figure out how many NatCat bonds you should allocate to the college fund portfolio using the goal-based framework.
Instead of the rudimentary “TIPS for needs, Stocks for wants” strategy, which is the financial equivalent of using a blunt instrument, TPA uses factor modelling to build a sophisticated mix. By combining volatile assets that offset one another, you can create a portfolio that offers both inflation protection and upside potential. It allows you to see the “failure rate” of your SWR alongside the projected growth of your inheritance.
In its essence, the TPA puts the financial goals inside the risk parity framework.
The Elephant in the Room: Implementation
I’ll be honest: The Total Portfolio Approach is hard to implement. Building a precise risk factor model is no joke. For a retail investor, you can’t exactly pull a professional-grade risk factor model off the shelf.
Think about this example. The industry loves to talk about the “illiquidity premium”, the idea that you get paid more for locking your money up in private equity or real estate. But right now, everyone is chasing “volatility laundering” (where private assets only look stable because they aren’t priced every day). Is the premium still there? We won’t know for ten years.
How would you price the illiquidity premium/discount on your rudimental excel model?
However, you don’t need to be perfect to be successful.
You don’t need to know if a 5% or 10% allocation to a diversifier like Trend Following or NatCat bonds is “optimal.” What we do know is that having some allocation is almost certainly better than having none. The biggest lesson we can take from the TPA is to look at our portfolio as a whole instead of a collection of separate “closets” targeted for made-up aims (growth, stability).
Part of the challenges in building a stochastic model to optimise for financial goals are similar to those faced by risk parity: getting risks and correlations right. Ain’t easy but we can borrow a page from the Risk Parity playbook for that.
Instead of complicated formulas, use a “Leverage Dial” approach:
- Start at Neutral: Begin with a zero-leverage, diversified base.
- The Dial: Turn the risk “up” or “down” based on your specific cash-flow needs.
- Revisit Regularly: If your kid’s university fund is already 100% covered, dial the risk down. If you’re behind on retirement, or want to prioritise that, you might keep the risk higher.
- Tactical Liquidity: If your portfolio is configured correctly, you can sell off the “winners” (assets that recently surged) to cover unexpected expenses without gutting your long-term strategy.
If you aren’t based in the US, a portfolio full of USD-denominated assets presents a major challenge: how to manage USD volatility. There are some useful tools in our toolbox, like non-USD bonds, gold and the currency sleeve in trend following. The biggest risk is something like April 2025, when a fast USD depreciation hits at the exact same time as a stock market crash: a double whammy for international portfolios. But this is only a risk for short-term goals and, in those circumstances, can be managed in an ad-hoc way: insulate a part of the portfolio. In the long term, I still think being long USD is beneficial from a carry point of view.
The Bottom Line
True stability doesn’t come from avoiding volatility; it comes from diversifying volatility. By moving away from rigid asset buckets and toward a framework that understands how risks overlap, you can build a portfolio that handles the trade-offs of real life. It’s about making sure your capital is actually working, rather than just running on the spot.
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