Trading Advice from Nobel Prize Winner?!

Almost anyone who trades knows about the Sharpe ratio 📈. It’s a measure of risk earned in excess of the risk-free rate per unit of volatility 📊. The formula basically tries to answer the question: how much risk did you assume to achieve that return? 🤔

The man who invented the Sharpe ratio, William Sharpe, is a Nobel Prize-winning economist whose latest project addresses what he calls the ‘Nastiest, Hardest Problem’ in retirement: how to ensure your money will last your lifetime 👵👴.

Imagine you’ve been investing diligently for 10 years and have built up a nice portfolio of $1M from a total capital contribution of $500,000 💰. Then, in the span of three months, all those profits disappear, and your original stake is now worth only $400,000 📉. Ten years of wealth-building down the drain in less than a quarter 🕳️. That’s what happened to investors in 2008 🗓️.

Of course, with the benefit of hindsight, we know that the markets not only recovered but doubled 📈. However, many people—most likely the majority—panicked and sold at the bottom, then took years to get back into the markets 😟. It’s easy to say that investors should hold through thick and thin, but as we know from trading, nobody ever does 🤷‍♂️. We all sell out at the bottom 🛑. At that moment, no one is thinking about compounded returns 20 years forward 📅. We are all just trying not to become homeless 🚶.

This is the precise problem that William Sharpe has tried to tackle, and he has come up with a rather elegant solution to help investors protect themselves from their worst instincts 🌟. As he tells Barron's, “The idea is that you segment your money 💵. It’s similar to using ‘buckets’ but with a time component 🕰️.

In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury Inflation-Protected Securities] 🏦, and a market-based portfolio, such as one with stocks and bonds 📈📉. You have the key if you need to access the funds 🔑, but the idea is that once a year, you would sell the assets in that year’s lockbox 📦.

Why is this better than just putting all your money into a single account stream? Two reasons. One is financial 💵. By creating short-term lockboxes that are essentially made up of annuities, zero-coupon bonds, and TIPS, you ensure that you have the income stream to survive for the immediate future while allowing “long-term” lockboxes to remain in the equity market where the volatility does not affect your short-term needs 📉📈. The other reason is, of course, psychological 🧠. The math is the same in both scenarios. You only have so much money, and it can only compound in a certain way given the performance of the assets 📊. BUT! Your ability to weather the market storm is much more robust if you are confident that your income streams are assured for the near term 🌦️.

Ever have a day when one bad trade tripped you up? 😩 And then you started to revenge trade, and the whole account got annihilated over what was supposed to be a 0.5% risk? 💥 This is exactly the problem that segmentation tries to cure 🛠️. The true risk to our capital isn’t one bad trade, but what we do afterward 🔄. If you had no more money in your segmented account to revenge trade, the damage would be contained 🛡️.

Segmenting your capital by strategy, instrument, and lever factor also has optionality embedded into the process 🎲. Let’s imagine you are a venture capitalist, but instead of companies, you stake 10 different strategies in 10 different accounts 💼. Now some—perhaps most—will blow up or lose 50% of their value over time, especially if you use even a mild lever factor 📉. But one or two may be totally in sync with the current market environment and go on a massive tear, tripling or quintupling their value 🚀. That’s all you need to be overall profitable—but if you have all your assets in one account, you will never have the mental strength to let the winning strategies run. William Sharpe’s great insight is to simply harness the value of what’s working because you have the confidence to stay in the game 💪.