Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. The first version of this article was published in November 2024.

“Why not just put all my money into the MSCI World?”

Many of the affluent investors that we work with have a high degree of risk tolerance. They tend to invest in higher-risk, higher-reward asset classes, whether that is a simple allocation to public equity (like MSCI World) or something more complex such as direct investments into early-stage start-ups. The presence of such riskier investments is no surprise, given that most of those clients made their money as entrepreneurs - without a doubt also a more risky path to building wealth.

However, in the end, many of such client portfolios consist of only higher-risk, higher-reward asset classes. Our clients typically argue that their approach is based on the long-term expected returns of said asset classes. Take public equity, like MSCI World, MSCI ACWI, or more recently (again), many of the tech-heavy indices like NASDAQ: All of those indices have offered double-digit annualized returns (10-12% p.a. in EUR terms) over the last 5-10 years, despite ‘hiccups’ like COVID in 2020 or the inflation-driven correction in 2022.

If you really are looking to invest for the long term, the risk factors associated with equities (like volatility and the resulting drawdowns) might be less relevant for you. While we as a wealth manager would argue that there are better ways to invest from a risk-reward standpoint, there are admittedly many, many worse options to go with than a simple equity ETF. Volatility might cause substantial swings in the value of your portfolio, but hopefully, you’ll benefit from the long-term average returns we’ve been able to observe over the last decades, and can then rebalance to a more balanced portfolio once you need to draw on that capital. (Whether and when we will see a correction from the 10-12% p.a. annualized returns of the last 5-10 years to the 7-8% p.a. long-term averages is another question.)

But more often than not, in the world of affluent investors, they don’t plan to just leave their investment for the foreseeable future. They might want to re-allocate to other asset classes over time, such as PE or VC. They might need capital for a real estate purchase. Or they might require ongoing income to fund their lifestyle.

If either of those factors apply to you, you should be mindful of so-called path dependence. Let's explain what path dependence is, practical examples of the resulting risks in action, and lastly, ways to mitigate it.

Path Dependence Risk is the risk of an investor not achieving their respective investment goal due to non-linearity of the parameters that affect their outcomes. Admittedly it’s a bit of a clunky definition, so let’s break it down:

“Investment goals” can be both major or minor goals. Major goals would be what we refer to as Investment Objectives - the high-level goal you want to achieve as an investor, such as a certain return to hit an income goal, a certain risk limit, or qualitative factors such as a sustainability-oriented portfolio. Minor goals, in return, are the often numerous small tasks that together amount to investment success, for example being able to service the capital calls of your fund portfolio, which in return is one of the many pieces that make up your asset allocation, or having the cash available to pay an outstanding bill.

“Parameters” mean the measurable input factors on which our respective goal depends. The most common parameters that investors think of is typically return, i.e. the performance of an individual investment. Investors might also view return in the context of the invested capital, where more capital invested in a certain asset might necessitate a lower return or vice-versa. But an equally relevant parameter is also the other side of the equation, meaning how the invested capital and/or the achieved dollar return is spent. That might include outflows from the portfolio as a whole, for example for living expenses of the investor, or a reallocation of funds within the portfolio, for example when a fund in the fund portfolio is calling capital.

Lastly, and perhaps the hardest to explain with words alone, “non-linearity”. To explain it, let’s use my example from the introduction: That many affluent investors allocate a significant portion of their liquid assets to public equities, as equities have historically offered the highest average long-term return. 

On the basis of average returns, that approach is logically sound. If we look at the globally diversified MSCI ACWI Index, we can see that it generated an average gross return of 6,6% p.a. since December 2000. (The 10-year CAGR stands even higher at almost 11%).

But we can also see non-linearity in action. Since the inception of the index in 2000, the index only saw one year in which it actually generated a ~6,6% calendar-year return (in 2020). In all other years, performance was either significantly above that figure (peaking at 28,9% in 2019), or significantly below (at -13,0% in 2022):

Hence, as the name says - despite stability of long-term, annualized returns, calendar-year returns are non-linear. They fluctuate significantly from year to year, which can have a significant impact on how an investor might (or might not) achieve their goals. (More on that below.)

The same applies to the spending side. While most investors try to stay within a budget they set for themselves, there is always the risk of an unforeseen, extraordinarily large expense outside of what they had accounted for: Think an unexpected tax payment, an expensive home repair, or even a family event like a divorce or an inheritance tax bill. Within investment portfolios, a common non-linear parameter is the cash flow profile of a fund portfolio, often fluctuating both for the benefit of the investor (i.e. lower than expected capital calls and/or larger distributions) or against them.

To understand better why non-linearity can be such a risk, let us take a look at a real-world example.

Assume that you are an income-oriented investor. You start with a portfolio of 10.000€ invested in an MSCI ACWI index fund, and want to make a (admittedly large) withdrawal of 700€ at the end of each calendar year, in line with the (expected) long-term return of the MSCI ACWI. (We’ll exclude expenses and taxes for sake of simplicity.)

Let’s take a look at our definition of path dependence risk again:

If we invest over a 5-year period, having started in ten full 5-year periods since 2010 (i.e. between 2010 and 2019), we can see how non-linearity affects our overall outcome:

Admittedly, it was a good period for stocks, so the outcomes are all positive. But they still vary significantly: our best period (from 2012 to 2017) saw a return of +52%, while our worst period (from 2018 to 2022) saw a return of ‘just’ +9%. Depending on how much capital you required for income, capital calls, or other expenses outside of your portfolio, there is a real risk that you would’ve found yourself with a smaller portfolio than when you initially set out.

For longer-term returns, we can take a look at Vanguard’s famous Return Handbook to see non-linearity in action. For all 20-year holding periods between 1901 and 2020, our average return was 7,5% p.a., very close to the average return over the full period of 7,3% p.a. 

But depending on when you started, the outcome might look substantially different. You might be lucky and get the best 20-year return, standing at a stunning return of 17,2% p.a. Or you might be unlucky and get the worst 20-year return of a meager 2,9% p.a., just marginally ahead of Germany’s long-term inflation rate of 2,8% p.a. Add an income requirement as little as 1% of your portfolio per year (most that we see tend to be in the 2-3% range, if not higher) to that not-so-great 20-year period, and you would’ve seen your million-euro exit wither away.

So how can we protect ourselves from the risks associated with path dependence?

As with other types of risks, we can benefit from the ‘free lunch’ of diversification. Let’s use the example of our income-oriented portfolio again: if we are invested entirely in equities, we might hit a winning period in which our returns outpace the amount that we need to withdraw every year, or we might hit a period in which returns are challenged while still requiring ongoing income. It is such a situation in which diversification in our experience tends to pay off: While diversifying away from higher-returning asset classes such as public equities might result in a lower expected return, we might also see a lower expected drawdown. More practically, even in a year that is bad for equities, we might have other portfolio components such as fixed income or commodities that see less of a drawdown or might even show a positive return - and as a result, we can sell such assets off at a gain or at least a smaller loss to cover our expenses, while being able to ideally hold onto our risk assets such as equities until they recover from their drawdown. (It’s why we don’t look at a desired return, but a required return, for income-oriented portfolios. For more on that, check out How To Spend It, or reach out to us for a personalized consultation.)

For someone just starting to invest, we should also be mindful of market timing. In a prior article, I had shared that if we go by average returns, we’d actually be better off investing all of our capital in a single tranche rather than breaking it down into individual tranches. After all, being fully invested on Day 1 would mean that we benefit more from the long-term, on average positive return of the (equity) market. (Please highlight that I would advise against investing everything in one tranche despite the mathematical truth - more on that in the aforementioned article.)

But of course, that comes at a price: Less tranches means that we are fully exposed to a single 12-month path, and are thus subject to a worse 12-month outcome. Staggering our investment into multiple tranches effectively breaks the number of ‘paths’ from one into multiple paths (admittedly with overlap). Hence, despite the lower expected return, we also see better worst-case outcomes, reducing the loss in the worst scenario from -48% to ‘just’ -36%. And of course, that is for an all-equity investment - for a more diversified portfolio, we not only benefit from the different paths underlying different asset classes, but also from different paths from different starting points. 

And of course, don’t forget to hedge yourself against path dependence before you even get started on your portfolio implementation. To name two that come to mind:

Think about properly sizing your core portfolio in the first place. Our preferred way to do so is the Aspirational Investor Framework as the first starting point, but also driven by how much income you actually require (once again, see How To Spend It).

Consider how to best manage your liquidity so you don’t need to tap your portfolio for expected (and unexpected) expenses. Have a good overview of your liquidity needs and income streams, and make sure to have different liquidity-related Lines of Defense.

To many of our clients, moving away from the “tried and true”, equity-heavy allocation, can be challenging at first. After the decade-long rally in equities, driven by tech, AI, and low interest rates, it seems hard to think that we might see a fundamentally different return environment. But it’s exactly those times when it’s worth taking a look at your portfolio to assess where the risks you are taking are warranted, and where not so much - and whether an unexpected, but very possible market correction would have a fatal effect on the ‘path dependency’ of your lifestyle and portfolio.

Are you an affluent investor worried about how the ups and downs of the market could impact your portfolio - and with it, your and your family’s lifestyle? We’ve helped numerous affluent investors and family offices assess and their path dependence risk, and helped them hedge themselves through solutions that range from adjustments to their portfolio, to better liquidity options, to strategic frameworks preparing them for the worst case. We’d be happy to help you, too - don’t hesitate to reach out.