How Much of Your Portfolio Should Be ‘Mad Money’?

On this episode of The Long View, our guest was David Booth, the founder of Dimensional Fund Advisors and the author of Stay Calm: Learn to Embrace Uncertainty in Investing and Life. We talked about how financial science made investing more accessible, why ordinary investors don’t need to outguess the market, and partying at the ABBA Museum.

Here are a few excerpts from our conversation with David.

Why 80%-90% of Your Portfolio Should Be ‘Sensible’

Amy Arnott: If markets are generally efficient, what does that imply about the role and limitations of actively managed funds? Do you think the average investor should generally avoid active funds, or do you think there’s still a role for them, maybe as a smaller percentage of a portfolio?

David Booth: I think you’re onto something there with a smaller percentage. I mean, I’ve been around long enough to realize people are people. I mean, they get attracted to all kinds of wild ideas and strategies and ways to do better.

I’ve learned to say, OK, let’s take 10% or 20% of your portfolio, and you can deal with it. Call it mad money, invest in all these crazy ideas that you seem to be enamored with, but let’s make sure 80% or 90% of the money or is it invested in a sensible long-term way rather than argue with people that if they say, well, I’m really intrigued by this or that, I go, OK, well, it doesn’t float my boat, but let’s make sure we stick to what the evidence from the science tells us. We kind of stress that our approach is really based on scientifically based hope, as I would characterize it.

Without the science, hope really just kind of becomes a wish. That’s the transformation. If you would like to have a good investment experience, and then based on the science, there’s no reason why you shouldn’t have the expectation of having a good experience. If you want to gamble a little bit on all this stuff and predictive markets and all of that, I know what the long-term outcome of that sort of thing’s going to be, but I’m not going to waste my time trying to convince people they have a negative expected outcome engaging in those markets.

Can Investing Globally Ease US Market Concentration Concerns?

Ben Johnson: David, that, I think, leaves a lot of investors in a place where you choose to take a meal ticket for what is often described as the only free lunch in this business, which is just basic diversification. I’m curious about your thoughts and how they’ve evolved on diversification.

I think this is timely because where we sit now in this particular moment in markets more broadly is a moment wherein many of the major market index that we look at look increasingly concentrated with respect to not just the percentage of these index portfolios that are comprised by a small handful of names, but the amount of earnings that those names are generating, the amount of incremental capital expenditure that those firms are pouring into the economy. Is there a risk that diversification, just in its purest sense, just owning the basic market, is at risk of potentially disappointing investors?

Booth: Well, first off, I mean, I think those are legitimate concerns. It does suggest that you want to maybe focus a bit more on viewing stocks as being a global market rather than just the US. Internationally, there isn’t that concentration. If you had half your money outside the US, then half of that problem goes away anyway. There’s not really a great answer to that. It looks like the industry’s going forward; there might be a lot of concentration because that’s really where the great ideas seem to be concentrated in some narrow industries.

On the other hand, personally, I am worried about some of that concentration. Our basic investment approach is to hold all those stocks. We have a tendency to hold them in smaller amounts than they represent in the index, but I don’t know what the alternative is.

My guess is over the long haul, the markets will take care of that. In other words, one of my favorite kinds of examples is to go back to the gold rush. The gold rush in California in the 19th century, flurry of activity. It opened up the West, really, but who made the big money? I mean, you could argue it was Levi Strauss.

So, the point being, with all these high-tech firms and so forth, there’ll be winners and losers on that for sure. I don’t know if anybody can predict who the big winners will be and who the big losers will be, but there’ll be big winners and losers. And the economy, I think the benefit on the economy will spread out, and you’ll see benefit in a lot of the areas outside of this tech. But for the time being, that’s kind of the way the market’s configured.

Johnson: Yeah, I think that’s a classic example. I think certainly in that moment, though, it’s not one that anyone here lived through. I think many would’ve expected the big winners would be holding gold nuggets and not wearing blue jeans.

Booth: Yeah. Being a product of the ’60s, I can tell you jeans are a big deal, a big part of life.

Arnott: And still are today.

Valentina Djeljosevic contributed to this article.