Ingredients Matter: In Baking & Investing

Vanilla is a fascinating ingredient. It is one of the most popular flavors worldwide and is incredibly common in baked goods. The process of creating vanilla flavoring is time-consuming and labor-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 dessert.

Ingredients matter. So does the order in which they’re combined. In baking and investing.

Risk Management is the Vanilla of Investing

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 and makes the result much more enjoyable.

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, when properly incorporated, it helps create a well-balanced strategy, typically leads to more predictable outcomes, and can provide a degree of downside protection.

The “baked into” language comes up often in investing, especially from veteran systematic investors. 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 can improves the outcome.

At Blueprint Investment Partners, we believe traditional asset diversification is improved by adding in a measure of time diversification via trend following; in our view, it’s 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

The notion of process and repeatability has many applications for financial advisors attempting to create or maintain a top advisory practice. As it relates to advisors’ role as an investment quarterback for their clients, 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 worst time to decide on a risk management approach is in the middle of the process. The markets move too fast, the factors are too varied, and clients’ emotions become too complex – even for the most seasoned financial advisor. Plus, managing hundreds or thousands of households requires consistent, streamlined processes for efficient execution of rebalancing and allocation changes.

Follow the Recipe

Just as preparing to bake a cake, the ingredients of investing need to be mapped out ahead of time and then properly incorporated. 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 a process that maximizes the probability of achieving an outcome that meets (or even exceeds) expectation.

If you’d like to learn more about how Blueprint manages risk and reduces the impact of human behavior on investment decisions, please reach out. Or – to carry the analogy of this blog to its logical conclusion – we’re also available for casual debates about the merits of cake versus pie, cookies, etc.