Vanilla is a fascinating ingredient. It is one of the most popular flavors worldwide and is incredibly common for use in baked goods. The process of creating vanilla flavoring is time-consuming and labor-intensive intensive, which is why in its purest form it is also one of the most expensive spices in the world.
Vanilla’s widespread use and high value alone are not what makes it interesting. Take vanilla and add it to a cake mix and it enhances the flavor, turning an ordinary result into something great. But if you first bake the cake and then drizzle even the highest quality vanilla over it, you have effectively ruined the cake.
Vanilla is not intended to be consumed on its own. In isolation, it has a harsh taste and is not palatable due to the fact it is 35% ethyl alcohol. However, when properly mixed with complementary ingredients it becomes essential, making the result much more enjoyable.
Baking and Investing – ingredients matter
The investing equivalent to vanilla is a focus on risk. On its own, risk management will not help an investor reach their goals or necessarily improve the portfolio outcome, and it even “tastes bad” to some advisors and clients. But, properly incorporated, it helps create a well-balanced strategy and ensures more predictable outcomes.
I first heard this metaphor in the context of investing from one of the most successful money managers of the past 40 years – Jerry Parker. As one of the pioneers of the discipline known as trend following, his insights include priceless gems on risk management and other topics. I would encourage everyone to find out more about Jerry and his fascinating story. But the point is that having the risk management rules ‘baked into’ the portfolio in the right proportion is crucial. Like a tried and true recipe, a systematic investment process that allows rules to be executed automatically improves the outcome. We believe that adding a measure of Time Diversification via Trend Following, to traditional Asset Diversification, is the optimal way to bake risk management into the cake.
This concept also reminds me of a quote by the American statistician and engineer, W. Edwards Deming. He once said, “If you cannot describe what you are doing as a process, you don’t know what you are doing.”
After the Fact Does Not Work
This concept has many applications for advisors attempting to create or maintain an elite-level practice. As it relates to investing, it means that one cannot spontaneously decide when to begin and end a risk management process. To continue the metaphor, can you start and stop the baking process and still end up with an edible cake?
The markets move too fast, the factors are too varied, and emotions become too powerful at the moment, even for the most seasoned managers. Not to mention the fact that managing hundreds, or thousands of households require streamlined plans for efficient execution when making re-balancing and allocation changes over months or quarters, much fewer days or weeks. There is no time to decide on risk management approaches in the middle of the process.
Follow the Recipe
Just as when one is preparing to bake a cake, the ingredients need to be mapped out and properly incorporated ahead of time. This is particularly true for ingredients that on their own are difficult to enjoy, like vanilla or risk management. Neither can be added after the fact. The result of designing the proper recipe and executing with discipline is an enhanced process maximizing the probability of achieving the desired outcome.