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“Why shouldn’t I just put all my money into the MSCI World?”

That is one, if not the, most frequent questions that we get in conversations with affluent investors. Most often, when we suggest that they should diversify into other asset classes, such as fixed income or commodities. It’s a reasonable question, and more often than not, rooted in (some degree of) financial knowledge and investment success.

Financial knowledge, in the sense that they understand ETFs (and financial markets in general), and have come to the positive conclusion that index-oriented investments are likely a more reliable alternative to active managed funds and/or single stocks. Investment success, in the regard that most of such affluent investors followed the ‘winning trade’ of the recent decade - which was, simply put, to invest most of your capital into global equities. The results speak for themselves.

Hence, it’s understandable why an affluent investor would stay with what they know. But we still think that there are clear reasons why investors should diversify, i.e. not put all of their money into the MSCI World (or a comparable index).

But in today’s article, let’s go about this differently. Let’s not discuss why you should diversify, but rather, follow the logic all the way down. Because if the only thing that matters is the highest long-term return, why stop at 100% stocks? There’s might be some more ambitious approaches to consider.

(Just to be clear, the following, especially the next section, should not be taken as investment advice. Most investors should absolutely not put 100% of their wealth into stocks - as we will outline in a bit.)

Let’s play devil’s advocate with your hypothetical portfolio. You’re 100% in equities, and let’s say you hold the MSCI World, the ‘default’ for most German private investors. But if we’re optimizing purely for historical return, the MSCI World wouldn’t be the place to stop. Over the last decade it has been beaten by the S&P 500, so why hold the sluggish Europeans and Japanese at all? Go 100% US.

But then, why stop at the S&P? Gold has kept pace with (and at times outperformed) US equities over the last few years, and it did so while central banks were buying it hand over fist. So why not 100% gold? 

And if we’re being honest about what actually delivered the highest return over the last fifteen years, the answer isn’t stocks or gold - it’s Bitcoin. So why not simply go 100% Bitcoin? 

Most people are with you until you get to gold, and Bitcoin is usually where they draw the line. That reaction is interesting, because it points to the same thing that is often overlooked when people build an equity-only portfolio.

Every one of those ‘highest returns’ was measured over a window we chose after the fact. The S&P only beats the World if you start measuring in 2009 and ignore the 2000s, the “lost decade” in which US equities went essentially nowhere for thirteen years. Gold looks like a great asset from 2000, or from 2019, and like a catastrophe from 1980 (a buyer at that January 1980 peak did not recover in inflation-adjusted terms for like four and a half decades). Bitcoin has produced the best returns of any liquid asset in modern history, but has fallen by 77% to over 90% on four separate occasions along the way. Picking last decade’s winner and extrapolating it across the next forty years is not a strategy. (It’s why we, and most of our fellow wealth and asset managers, have that big “historical performance is not an indicator of future returns”, in bold, in our legal disclaimer whenever we speak about any sort of performance.)

The MSCI World is a good example. It is often used as the “diversified” option, but is now itself a fairly concentrated bet. By late summer, roughly 72% of the index was made up of US companies. The ten largest positions accounted for more than a quarter of the index, and technology was close to 30%. So when a client tells us they are diversified because they own “the world”, they are actually making a fairly large bet on US equities, and in particular on a relatively small group of large technology companies. That bet may turn out to be a very good one, and is without a doubt a better ‘bet’ than buying a handful of individual stocks. But it is still a bet.

Leave that game of chasing the highest past return aside for a moment, because there’s a more subtle, and more important problem hiding underneath the “stocks always win” argument. It concerns the difference between the return you quote and the return you actually compound.

When someone says equities return “about 8%,” they’re usually citing an average (an arithmetic mean). But you don’t get to keep the average. You keep the compounded (geometric) return, and the two are not the same thing whenever there’s volatility involved. The relationship is fairly simple - the more a portfolio moves around, the more difficult it becomes for the compounded return to match the average return of the individual years. 

Let’s say you have €100. Imagine an asset that gains 50% in one year and loses 50% in the next one. The average annual return is 0%. But €100 that goes up 50% and then down 50% is worth €75. Over one good year and one bad year you haven’t broken even, you’ve lost a quarter of your money (with a geometric return of ca. -13% p.a.). Extend that to +100% followed by -50% and your “average return” is +25% per year, while your actual result (the geometric average return p.a.) is exactly zero. The difference between the average return and what you actually end up with is called volatility drag, and it becomes bigger the larger the swings get.

That is why a lower (average) return, lower-volatility portfolio can potentially even beat a higher (average) return, higher-volatility one over time. A rough illustration:

Source: Cape May Wealth Advisors. These are illustrative figures, not historical data. They simply apply the rule above, that the compounded return is roughly the average minus half the variance, to plausible numbers. Capital is at risk.

Look at the first two rows. The diversified portfolio “gives up” 2.5 percentage points of average return, yet compounds at only 1 percentage point below pure equities, because it hands back far less to volatility drag. None of this is a new insight, Cliff Asness (the founder of AQR) wrote a paper in 1996, “Why Not 100% Equities.” He explains that an investor willing to stomach the risk of an all-equity portfolio could potentially generate higher returns through the somewhat counterintuitive thought of actually holding less equities. The reasoning works in two steps: 

First, by investing in a diversified portfolio, which holds asset classes that shouldn’t all incur losses at the same time, this increases diversification and thus reduces volatility by more than you potentially give up in performance. You get more return for the risk you take (a higher Sharpe ratio). And notably, due to the more stable performance of the portfolio, your geometric return is much closer to the arithmetic one - and almost matches the one of equities!

And secondly, boosting these higher risk-adjusted returns by adding leverage to this diversified portfolio, this way keeping the increased risk-to-return ratio which would lead to higher average returns when the risk level (in terms of volatility) is matched with that of equities. You can see this result in the third row of our table above: By bringing the diversified portfolio to the same level of volatility (i.e. from 10% to 20%) through the use of leverage, we can reach the same risk level as equities, but at a higher average return. The reason is simply that the diversified portfolio earns more return per unit of risk.

Of course you don’t have to double your risk level just to get back to equity-like risk levels. You could also optimize for equity’s initial target return, which you’d achieve with a lower risk level than 100% equities. Or, last but not least, simply be happy with a slightly lower return at substantially lower risk - especially if it’s the return you actually require (for income or other long-term reasons) as opposed to simply wanting, well, higher returns.

No matter how you choose, that approach has offered better (risk-adjusted, and potentially absolute) returns than a portfolio consisting entirely of equities. Or in other words, and once again counterintuitively - just because you are invested in 100% stocks, the typically highest-returning “stand-alone” liquid asset class, doesn’t mean that you would necessarily generate the highest possible return.

The sophisticated “100% equity” investor has a ready answer to all of this. “Fine, I’ll have to live with drawdowns and volatility, but I have a long horizon, so I can sit through a downturn and wait for my portfolio to recover.”

And for a certain kind of investor, that’s correct. If you’re still accumulating, still earning, and you don’t need to touch the portfolio for twenty years, a crash is an inconvenience and arguably an opportunity. Sitting it out is the right move. 

But a lot of the clients we work with are no longer in that phase. They might have already had their liquidity event. Therefore their portfolio is no longer being fed by a salary or the next funding round, but instead is now expected to pay them. And the moment a portfolio has to fund withdrawals, “I’ll just sit it out” will not work out anymore. The market takes its cut, and in a worst-case scenario, you have to sell while prices are down to pay for this year’s spending. 

This is called path dependency risk, and it’s the one of the most underappreciated dangers for a recently exited founder living off their capital. To make this more tangible, take a 10M portfolio, from which you draw €400K a year (a 4% distribution) to fund your lifestyle expenses. 

Two scenarios:

These are very different outcomes, the only difference being the depth of the drawdown. This is why Morningstar’s retirement researchers keep finding that equity-heavy portfolios support lower sustainable withdrawal rates, not higher ones: the extra volatility and path dependency risk more than offset the higher expected return once you're spending from the pot.

To put it a bit more directly: We know entrepreneurs who are, in effect, 100% invested in equities (sometimes 100% in just a few stocks). And in most cases their wealth has grown over the last 5-10 years, and they feel vindicated. But “it worked” and “it was the right risk to take” are different. If those same portfolios experienced the 2000 or 2008  crisis while drawing an income, a good number of them simply wouldn’t have made it - effectively requiring them to build another fortune, to have another life-changing exit. Possible? Yes - but much more hard work than simply reconsidering your portfolio approach ahead of time.

At this point the fair objection is: “Alright, but equities did deliver, and the economy keeps growing. Why bet against that?” We wouldn’t bet against the economy - but we’d point out that the extraordinary equity returns of the last fifteen years rested on a specific set of tailwinds, and we would question whether they can repeat it.

Interest rates fell from high to zero, which lifted valuations across the board. Corporate tax rates came down. A Federal Reserve study found that the decline in interest and tax rates alone mechanically explains over 40% of the real growth in US corporate profits from 1989 to 2019, and that the fall in risk-free rates accounts for essentially all of the expansion in price-to-earnings multiples. The tech boom and the wave of excitement around AI helped drive the run we’ve just seen. 

The trouble is that rates are not at zero anymore, inflation is under pressure since late 2021, tax cuts are harder to come by when governments are running large deficits, and the structural helpers of the last few decades (globalization, a growing working-age population) are fading. Meanwhile, valuations already price in a great deal of optimism. The cyclically-adjusted P/E on US equities is around 41 right now, against a long-run average closer to 17, a level only ever exceeded at the peak of the dot-com bubble. Expensive markets can stay expensive for years, so valuation alone won’t tell you when the market turns. But it does show how much optimism is already priced in, from here, companies have to outperform expectations (whether through AI efficiency gains or other means) to keep delivering strong returns. 

For someone living off their wealth, what matters is the compounded return they actually end up with and whether the portfolio can survive the bad years. You need to stay invested long enough to benefit from the good ones. 

In practice that tends to mean three things. 

First, working out how much risk you actually need to take, which isn’t the same as how much you’d like to take. That follows from how much you plan to spend, and when. Once that is clearer, being deliberate about how much total risk you take (at least in the part of your portfolio from which you plan to draw income) beats simply taking whatever a 100% equity portfolio happens to return that year.

Second, replacing ‘unused’ cash and pure equity concentration with diversifiers: a range of different types of bonds and a commodity and gold allocation. As outlined above, diversification really is the “free lunch” it is often described at, at least from the perspective of risk-adjusted returns.

And third, where it fits, using modest, institutionally-priced leverage or capital-efficient structures to lift the return of that diversified mix toward your target, rather than reaching for return by allocating into more volatile assets. That’s the Cliff Asness insight, and it’s a similar idea to the Structural Alpha idea: earn more per unit of risk, rather than simply taking more risk.

If your portfolio is heavily invested in equities, it may be worth taking a closer look at how it would behave in a downturn, especially once you are drawing income from it. We work with affluent investors to build portfolios around their liquidity needs, time horizon and tolerance for risk. Sometimes that starts with a simple second opinion on the portfolio you already have. If that’s something you resonate with, feel free to reach out.