A few nights ago, I walked into my kitchen to the sight of my daughter and her friends, covered in flour, baking a batch of chocolate chip cookies. As I watched them stirring and mixing, I thought about how cool it was that all of the different ingredients come together to make something special. And I have to say, those were some darn good cookies.
This made me wonder: what is it that makes a chocolate chip cookie taste good? Is it the quality of the ingredients, the correct proportions, or maybe how everything is put together?
To research these questions, I started with the two most popular chocolate chip cookie recipes I could find on the internet. Rather than looking at them in the traditional way (1 cup of this, 2 tbsp of that, etc.), I decided to organize the ingredients into two pie charts:
I was amazed by the similarities between the recipes. Although there are differences, the core ingredients (flour, eggs, sugar) remained the same and had similarly sized proportions.
This reminded me of the asset mixes I see in client portfolios every day. As it turns out, there are several parallels between a good cookie recipe and a good asset allocation mix:
- “Winging it” is a recipe for disaster. It’s virtually impossible to make a decent chocolate chip cookie without a good starting point. Throwing together some eggs, sugar, flour and chocolate chips might taste good, but it also might give you a stomachache or end in a nasty mess. Similarly, throwing together a bunch of investments (a stock or two and an ETF highlighted on a Superbowl commercial) might perform well at times, but odds are you’ll end up feeling sick at some point.
- Leaving out a core ingredient can lead to serious problems. I once forgot to add eggs to my cookie batter, and this resulted in a full trash can. The core ingredients in an investment portfolio are stocks, bonds, alternatives, and cash. They each have a key role: growth (stocks), safety (bonds and cash), and diversification (alternatives). If you exclude one of these key ingredients, you might be tossing your portfolio in the trash as well.
- Working around a huge addition is impossible. Adding two cups of kale to our dough would ruin the whole batch, and there are no small tweaks available to save it. When investing, large concentrated positions (say a huge chunk of a biotech stock or a pile of cash) often dominate a portfolio and shift all risks to that one holding. Keeping these positions in check is a great way to manage risk.
- Ingredients do not have to taste good on their own to add to the final result. Eating a chocolate chip or a pinch of brown sugar before they go in the bowl can be a nice treat, but taking a sip of vanilla extract will leave you gagging. Each ingredient makes sense when it’s all mixed together. When investing, we see that each asset class has their time leading the pack and it’s tempting to want to load up on the best recent performers and avoid the rest. It is important to balance the “tasty treats” with the “baking soda,” which might taste bad now but helps the portfolio rise. In the 2018 stock market correction, these “baking soda” investments were the ones that performed the best. A solid overall mix makes for a better long-term result.
- Using high-quality ingredients is important. Even if you have a good recipe at the start, using old eggs or expired butter can leave your cookies flat. It’s also true that the holdings put into the mix make a big difference when putting together an investment portfolio. Using high-cost, tax-inefficient or poor-quality investments will leave a bad taste in your mouth. With some work, excellent investment options can be found that will compliment your mix.
My family and I enjoy watching great TV chefs, and we are always amazed at their techniques. There are definitely parallels between their skills and the skills I use in building investment portfolios. For example, I always start with a plan that fits the client’s preferences and needs (no winging it), and I diversify across different a variety of asset classes (use core ingredients).
Thank you Julia Child, Martin Yan, Michael Symon, Gordon Ramsay (and countless others) for the great investment lessons!