The anti-FOMO movement

There are n strategies, each with returns $r_i$.  Ranked top to bottom, so $r_1$ is the strategy with the highest return (long term).  Why not just put your wealth all in strategy 1?  Putting only a fraction of it in 1 and fractions in 2,3,...n leaves one with a feeling of missing out.  I suspect if you live to be 640, then this would be the effective result of the ideal allocation strategy.  Indeed if you have a 60 year perspective, this might also be the case.  But history doesn't always repeat itself.  So you can never be sure the future will continue sufficiently to be like the past.  Hence you'll want to diversify.  For example if you are Russian, living at the turn of the twentieth century and happened to note in 1901 that the St Petersburg stock exchange was your $r_1$, and decided to put all your wealth in there, then you'd be in for a shock when the Russian revolution came and wiped your wealth to zero.  If you were an ultra risk-adverse German post WW1 and thought you'd keep your money in nice liquid deutsche-marks, then the hyper-inflation would have likewise wiped you to effectively zero.

The degree to which you trust the institutions which underpin the strategy returns you feel you have access to is the degree to which larger and larger fractions of your wealth will go into strategies 1, 2 etc. rather than into tail end strategies.  Conversely, the degree to which you are uncertain of the future of those enabling institutions (and this, to be sure, is an uncertain act of political tea-leaf-reading) determines how distributed your wealth will be.  Your degree of confidence in strategies 1, 2 also grow to the extent that your future wealth-investment time horizon is long.

Besides the above unknown unknown, is the idea of correlation.  If all strategies 1,...,n are fully correlated with each other, then each of n is as good, in this one respect, as all the others.  But the degree to which any two (or more) strategies are uncorrelated or lowly correlated, opens the possibility that there was a combination of these strategies which was ideal, in some wider, as yet to be defined sense.  

So a world with a lot of serious unknown unknowns presents a difficult environment for the ideal strategy allocation algorithm, as does a world with cross strategy high correlation.  Thankfully so far the world we live in is somewhat known, somewhat predictable .  And this is the space that the theory of the ideal strategy allocation algorithm can work within, where the past can tell us something about the future, and where strategies have less than perfect correlation.

Floor entropy and ceiling noose

The whole space of strategy allocation is shaped by two massively important risks - inflation risk and gambler's ruin.  The first bites your wealth from below, when your allocation strategy overall is too focused on principal protection, where the return can be below the inflation rate, and the second bites your wealth from above, when your allocation strategy overall is focused on principal growth and your 'bet on green' at the roulette table of life stops you out and you go home early.  Each fate is ugly, you either dying in dog food penury or dying young in a bloody accident.  It ought to be the goal of an ideal strategy allocation approach to avoid both outcomes and instead enjoy healthy lunches - free and paid for - over as long a stretch of your life as you can.

This blog post is in general a post for everyone, but of course poor people first need to arrive somehow at a pool of investable capital (separate from their day to day living costs and the capital they have for investing in their business).  I think it is a fair statement, at this early stage, to suggest that younger folks with capital can afford to be closer to gambler's ruin than older folks, since they can trade their labour, brain, body, time for paying their today costs, whereas post-retirement oldies have less flexibility and hence have a big income draw-down demand.

How close a young investor gets, of course, to gambler's ruin, is a cultural question as well as an economic one.  Their appetite for risk ought to be higher, insofar as making the tilt for wealth growth over wealth protection is paid for by their greater expected lifespan. I've heard it said that private equity / startup investors like to hear from a founder that they failed once or twice in the past.  Secondly, bankruptcy law is all about buying back in gamblers who have reached ruin with their firm.  Our culture of long term GDP growth has some of this risk taking burnt in.  There's a sense that the fable of Icarus is seen not only as a warning but also as admirable somehow.  Back through human history, we have moved forwards in time by combining our prudence with our spirit of adventure.

And vigour, life, vitality, novelty, creativity, growth, these are all inter-connected concepts culturally.  As opposed to self-sustainability, entropy, predictability, familiarity, maintenance.  But the ideal strategy allocation algorithm must partake in all of those concepts.   Unfortunately, all too often, both of these existentially definitive risks are under-emphasised on behalf of investors.  But wealth generation is in the limit a lifetime activity (longer, for companies, or for aristocrats or for anyone who plans to leave an inheritance for their loved ones).  It is a common fate for us collectively to understand the importance of long term planning only as we get to be old.