Is Optionality An Asset Class? What About Ergodicity?

It's been a while since I've blogged anywhere. The world is crazy. The capital markets are crazy. Nothing is working like it is "supposed to." Client portfolio are going along for the ride because despite what I just said, the market goes up when it shouldn't all the time. Personally, life for my wife and me is generally terrific.   

I got into a brief exchange on Twitter with Mark Baker (@guruanaerobic) about asset allocation stemming from a comment he made about Bitcoin. Mark is a great follow if you're not already doing so. One thing I love writing about is the manner in which asset allocation might be evolving or maybe how we should think of it individually as we all cycle through our investing lifetimes. 

As a product of our convo, I had the idea for building an asset allocation model not using any of the typical terminology like stocks/bonds/cash, not to necessarily encourage crazy behavior with your money but to zoom out a little bit to focus on attributes that stocks/bond/cash might have or not have. For example, if US Treasury Bonds are return free risk, how much exposure should you actually have? 

The first asset class is Ergodicity. The basic idea is that if you just get out of the way and let it, whatever it is, do its thing, it will do its thing and reward you over the long term. The easiest application I can think of here is equities. I've been saying since long before I'd ever heard the word ergodicity that the stock market is going to average its 7 or 8% or whatever annual return no matter what you do. The more you do the more you risk increasing your lag to that 7 or 8% or whatever annual return. Great investors and traders will be an exception of course but I am not willing to bet clients' money that I am great so I try to trade as little as possible. That does not mean no trades but there are several names in the portfolio that have been there more than 15 years doing their thing because I let them do their thing.  

This chart is a good example of ergodicity with a couple of individual stocks that have been in the portfolio for at least 15 years, longer for the pink stock. The names don't matter.

One stock has wildly outperformed, the other has lagged but is intended to be very unvolatile and has yielded 2.5%-3% most of the time I've owned it. Hopefully I'll never need to sell these but if at some point the respective stories change, then I'll sell but in the mean time, I will just let them do their thing.

What else could be ergodotic? Maybe real estate, not sure but if you think something is ergodotic, then it is, no wrong answers here, just whatever is right for you. 

Asymmetry is another "asset class" I would include. Cryptocurrencies are a simple example as are lottery ticket biotech stocks and maybe certain natural resource stocks. 

Next is optionality which for me is cash or cash proxies. The optionality doesn't have to just mean for investing but also optionality in life. Maybe someone gets to 40 or 50 years old and wants to do something completely different in their life and that new endeavor will pay a lot less. A good buddy went from the mortgage industry to becoming a nurse. Knowing little about the medical field as an EMT and knowing a little more about the finance industry, those are pretty disparate jobs. Anyone wanting to make such a big change, especially one requiring school in between would have greater optionality to do this with cash set aside. 

A year ago we bought three acres of land next to us as a buffer to development on our little hill here in Walker. We have optionality to build on it. We have optionality to just sit on it. We could invest a little more into it with a septic system to then sell and let someone else build. I don't know if we could ever grow any type of food on it in some sort of Doomer Optimistic outcome (I know some fruit can grow in out forest, not sure what else). So is land optionality? I think it can be. 

The idea of tail risk protection has always appealed to me, a small allocation to something that will go up if the rest of the market takes a serious hit. In the last few years tail risk has become much easier to allocate to. The first fund I am aware of is the Cambria Tail Risk ETF (TAIL) which is a client and personal holding. There are others coming. The Simplify Tail Risk ETF (CYA) started trading a few weeks ago, no position in that one but how about that symbol?

I've maintained a position in TIPS for clients and personally, I believe in inflation protection as an asset class even as risk of price inflation has remained low for a long time until recently. Some think of gold as an inflation hedge. I'm a maybe on that, it certainly used to be but seems to not be capturing the recent inflation event. I own gold because it tends to not look like the stock market far more often than not. Some say Bitcoin is an inflation hedge. It is up over 100% YTD as price inflation is running much hotter than it has in a long time so we can't really refute Bitcoin as an inflation hedge but Bitcoin could just as easily be up for reasons having nothing to do with inflation. I believe in the latter, it is not primarily hedging price inflation except as a happy accident. Am I wrong about that? Absolutely could be wrong about that.     

Experiences. This is a stretch to label our Airbnb something other than passive income. We have been very lucky with our rental. For a lot of our guests, the experience of being at the cabin with the view is the reason they booked as opposed to going to some city and finding an apartment that is a good mix of cheap and well located for what you want to see in that city. We are in part, allocated to offering and getting paid for other people to have an experience. Maybe it's a stretch but we have a view that we've been able to monetize. 

Have you been inundated with ads for things like art or other collectibles? I have a few baseball cards. A few years ago I bought a Bobby Orr hockey card from 1971-72 for about $20. I just saw the same card with the same grading on eBay for more than $300. That sort of price appreciation is what I'd call a happy accident which is this asset class (I realize I just used that phrase up above). Sure if I had a couple of hundred cards bought for $20 each that were all worth $300, that'd be enough to move the needle for us. $60,000 would be close to a year and half's worth of expenses. However I don't have it in me to spend thousands of dollars to bet that values of sports cards will grow to the sky. Where this sort of thing is concerned, if you like/love it buy it but don't spend more than you're comfortable with.

These two are from the mid-1930's. To me, they are stunning pieces of art in a subject matter I love. Each card was in the $20's. Some cards from this set are worth a fortune. It's a good bet but not a bet on an ergodtic outcome, that these cards will at some point go for $100 each. Great if they do, don't care if they don't. A more aggressive risk tolerance than mine might view this much differently. 

Do you view your career/business as an asset? My practice isn't necessarily a marketable asset but it is an asset. Like many things in life, the more I put in the more I will get out. I invest time into monitoring, learning new things, customer service and so on and while outputs are partially out of our control, maybe entirely out of our control, I'm not leaving anything on the table in terms of the effort I make. It is easier for someone who is self-employed to view their vocation as an asset. When I worked on the trading desk at Schwab back in the 90's I certainly had fun but there was no asset really. The difference was skin in the game.  

The last one is making your life easier; convenience. Here I mean things like tools, but you might have different things that would add convenience to your life. At some point we may need to go from plowing our road with an ATV to using a tractor if/when I can no longer shovel a lot of snow (when the snow is very deep, clearing it is a mix of plowing and shoveling). I expect no direct monetary return but if we can stay here until we are really old then we'd save money not having real estate transactions and depending on the circumstance of a possible move, we'd save money being mortgage free for a longer period. So an indirect monetary return. Taking care of your health can fit here too. Staying strong and avoiding chronic maladies will result in thousands of dollars not spent on medical care. That's probably a via negativa return on your investment.  

How much should someone allocate to these "asset classes?" If your financial plan is relying on normal stock market growth then the ergodicity of the stock market would probably be your largest allocation. 

When I talk about asymmetry I say to start at 1% or maybe less and let it grow. It's been long enough now where my exposure to crypto is probably 7-8% and my intention is to just let it keep growing. I might add a little on dips or not, sometimes I have and sometimes not, but it is almost all house money. Yes, that is a gambling reference which helps gives context about how I view crypto exposure.

I have more in optionality, cash, as a percentage than most people do. I've disclosed that before. We live well below our means, I don't want to retire, I don't want to risk being emotionally distracted by my own portfolio that it leads to emotional decisions in client portfolios (have had good luck on that front). Beyond that, this is a pretty psychological decision. How many months of expenses in an emergency fund makes you comfortable? If you don't like your job but can't bring yourself to try something else, how much psychic value do you get knowing you have enough cash to make a big change if you wanted to? We're all different on these points.  

Go back to the first paragraph of this post. Do you agree that things are really strange these days? Cool if you don't but if you do, then I think it makes sense to view asset allocation which is as important as it ever was, a little differently.