In my last article, I posted the question whether it is prudent for a high risk-tolerant investor to invest all in one strategy. The Kelly formula suggests that it is not a good idea. The reason "I can afford to lose all" does not give me the license that "I should invest all". In this article, I'd like to elaborate on two more points in this framework.
A brief summary on the last article. The question I asked: Given only the investment choices of SPY and cash, what is the optimal strategy to grow the bankroll? I provided a table of the SPY statistics on various rebalancing schedules (here). For readers who have a better investment strategy than SPY indexing (for example, value investing, dividend growth investing, small stock investing etc.), feel free to replace SPY with your own, and invest more if your betting statistics are more favorable. But, since there is no strategy that gives you 100% certainty, a portion of your portfolio will need to be invested in something else.
The under-appreciated value in cash or bond
What are the choices for the "something else"? Before we make a selection, we need to know what this portion of your portfolio is for. The reason, according to the Kelly formula, is to balance growth with potential loss, so that when a catastrophic loss occurs, re-investing using the Kelly formula allows the portfolio to recover optimally. I can easily point to the bear markets when all stocks lose values regardless which growth strategy is used. This is exactly when you need the money from "sitting on the something else" to reinvest in your primary strategy. Thus, the "something else" needs to have low correlation with your primary strategy. For SPY or dividend growth investors, since the primary strategy is a long-term bullish bet, the ideal second strategy on "the something else" should be a short-term bearish bet.
This is quite difficult! It is basically asking the investor to have a split personality. I don't think many investors can master the balance between two opposite strategies. In lieu of it, what are the other choices? The alternatives are quite simpler, bonds and/or cash. In a moderate to high inflation environment, bonds are the better choice. In a low inflation environment like today, holding cash is actually good.
It is indeed an under-appreciated value in bond or cash: not from the perspective for capital growth, but from the perspective as an insurance policy (or a delayed purchase plan) to your primary strategy.
Another situation that may be of interest to the readers is the following:
A retired investor who is in good health, has a large retirement account and a long investing horizon. He needs a portion of his investment amount to supplement his daily expense, but not the entire bankroll. What should his strategy be given the choices of SPY and cash?
We can borrow the "laddering" strategy from the bond investing strategy book, i.e., investing a portion in long-duration to get a higher interest, and the rest in short-duration to address the need for cash accessibility. Instead of using bonds, we replaced them with the Kelly ratios of various rebalancing schedules. For example, if you decide to have 70% in long term and 30% in short term, you will invest the 70% according to the 1-year rebalancing schedule (which is 60% in SPY and 40% in cash), and the 30% according to the 1-month rebalancing schedule (which is 20% in SPY and 80% in cash). Your total investment in SPY is: 70%*60%+30%*20% = 48%. At the end of 1 month, you rebalance the 30% and leave the 70% untouched, and so on.
This may be an interesting strategy for early retirees who want to continue participating in capital appreciation via investing in stocks.