The hardest part about implementing a truly diversified approach that can do well across economic regimes is that it requires a change in how most investors think about their role.

Most investors I’ve met think of ‘investing’ as synonymous with ‘picking high returning assets’ and so the way they spend their time tends to reflect that. Our investing framework redefines investors as portfolio managers looking at the overall composition of the portfolio first. Picking individual assets is still a significant part of that role, but it is reframed to think about assets within the context of their overall macroeconomic sensitivities.

I’ve noticed a general evolution among my peers in terms of how they think about investing.

Broadly speaking, it breaks down into Three Stages.1

Stage 1: Probability

Stage 1 is framed by thinking in terms of probability. People in this stage tend to make investment decisions by asking the question “Is this likely to make money?”

Probability is a powerful tool for helping people make better investment decisions and even a basic understanding of probability makes a big difference in helping people make better investment decisions. People who use probability investing are going to avoid some of the worst possible investment decisions like buying lottery tickets or gambling, but have an overly simplified model.

Stage 2: Expected Value

Stage 2 is framed by thinking in terms of expected value. It improves on thinking strictly in terms of probability because it also considers the potential payoff. An outcome with only a 20% probability but a 10x payoff can still be an intelligent investment.

In my experience, the vast majority of non-institutional (and even many institutional) investors are at this stage of investing. When evaluating a new investment opportunity, they tend to try and determine the expected value of an investment and how it compares with other things they could invest in.

Most investing discussions we see are discussions around the expected value of different assets or strategies. They say, “I like this stock and that stock”. They look at each individual piece on its own: “Which of these investments is going to do the best?” Their dominant mental models are expected value and opportunity cost.

Stage 3: Portfolio Construction

Stage 3 is framed by thinking in terms of portfolio construction. In the same way that thinking solely in terms of probability seems limiting from the Stage 2 perspective, thinking about assets solely in terms of expected value is limiting from the Stage 3 perspective.

From Stage 3, an investor thinks about not just expected value but the expected path. They consider the portfolio holistically and see how investing in lower-returning but uncorrelated or negatively correlated individual assets can create a superior outcome at the portfolio level.

Using the principles of diversification, Stage 3 investors are thinking “I should put some of my money in the investment that I think is going to do the best and then also put some in investments that I think won’t do as well but are complementary because if I rebalance between them, I improve the overall performance of the portfolio.”

Thinking in terms of expected value does not discard the concept of probability, rather it incorporates it into a broader model.

In the same way, thinking in terms of Portfolio Construction does not discard the concept of expected value, it just places it within the context of the overall portfolio. Indeed, we believe that thinking in terms of expected value is made even more valuable in stage 3 because it puts it in a more productive context.

If you’re a stock picker or private equity investor, this would imply including assets that can do well in periods of inflation or decline. By rebalancing between the quadrants, this would give you more dry powder at precisely the right moment. It can function as an entrepreneurial put option to deploy capital in your area of expertise just when deals are most abundant.

Most investors we know today are concentrated in offensive assets like stocks, bonds, and real estate. They have invested overwhelmingly in periods where these assets performed exceedingly well, which we think has created a strong recency bias towards those offensive assets, particularly if viewed through the Stage 2 lens of expected value.

But we’ve also seen that it can suffer through periods of extended poor performance. Are investors focused on these offense-only portfolios today any different from the GI in 1945, that didn’t want to touch stocks? Or the Baby Boomer in 1980 who didn’t want to touch bonds?

We believe that investors looking to pick individual assets like stocks, private companies or real estate will be most successful if they do that from a stage 3 perspective by looking at individual investments within the context of a broadly diversified portfolio that includes components that can do well in each macroeconomic regime.


  1. This structure is very loosely inspired by Robert Kegan’s model of human psychological development which built on the work of Jean Piaget with the general idea being that each stage subsumes and incorporates the previous stage in a sort of Hegelian thesis → antithesis → synthesis way. Stage 3 does not discard Stage 1 or Stage 2, merely incorporates them into a broader framework.