Throughout history, mankind’s relationship with fuel has been quite rational. Early man was drawn to fire, and thus to wood, which cooked well and warmed well. Then in the middle 1800s, when technology made it feasible to burn other fuels efficiently, mankind turned to coal, an abundant fuel that was soon joined by natural gas and oil.

In a mere 150 years, coal, oil, and natural gas have taken over. Today these three account for roughly 80 percent of the world’s total fuel consumption. Yet nothing intrinsic changed as we adapted to new fuel technologies. Whether we burn wood, coal, oil, or gas, we’re doing the same thing: We’re creating energy—or, more specifically, BTUs. The BTU, or British Thermal Unit, is the amount of heat it takes to raise the temperature of 1 pound of water 1° F. A BTU is energy, a thing modern man cannot do without. And one BTU is about as good as another.

As consumers of energy, we are less concerned about what generates it as we are with how much it costs and how readily available it is. Some of us choose the direct on-site burning of the fuels that will produce our coveted BTUs, while others opt for the indirect method of buying the BTU-making electricity that is generated from various fuels. Either way, this is derived demand. We desire the BTU, the final product, which is reflected in the demand for the source of that product: fuel.^[1]

Technology is a wonderful thing. It allows us to burn a wider variety of fuels while also increasing our ability to produce more goods and services with that energy. If our relationship with energy were irrational—and, hence, addictive in nature—why, as a country, would we use less energy the larger we grow?

There’s a downward secular trend in the ratio of total BTUs consumed in the U.S. per unit of gross domestic product (see Figure 8.1). This trend has accelerated since the 1970s, with our BTU consumption plummeting across the OPEC decades that have been marked by higher energy prices. Importantly, this reflects a steady improvement in the energy efficiency of the U.S. economy. What’s more efficient than getting more (growth) out of less (energy)?

Figure 8.1. 

This efficiency is evident not only over time, but each time there is a periodic shift in energy prices. For instance, real (inflation-adjusted) changes in the price of oil have shared a negative (or oppositional) relationship with the consumption of BTUs per unit of GDP (Figure 8.2).^[2] In particular, as the price of oil has risen, the energy efficiency of the U.S. economy has improved. This is clear evidence of an economy and a populace that responds appropriately to market signals: We will squeeze more out of less when it is economical for us to do so.

Figure 8.2. Percent Change in the Inflation Adjusted Price of Oil Versus Percent Change in the Decade-Long BTU/GDP Ratio

The data confirms our very rational relationship with fuel in general and with the BTU in particular. Not surprisingly, this is the same level of rationality exhibited by many an investor. Think of it: Any way it is derived, the BTU is the result—it is energy, what consumers want and need and will rationally acquire by way of a number of fuel sources. Similarly, think for a moment about the investment return. If you invest $1 and it becomes $2, you earned $1, which was the return that drove you to invest in the first place.

But to get that return, you had to rationally select from a broad number of return-generating investment vehicles, just as modern man selects from a wide menu of fuels. Any one stock or bond can produce a return, and investors have several thousand of these available. Then there’s the return-generating world of investment funds, such as mutual funds, exchange-traded funds, and hedge funds, all of which are built in terms of specific investment styles and mandates and are attached to varying degrees of cost and risk.

But which ones are for you? Pragmatically, you want to purchase the ones that will get you what you want, in the amount you want, and when you want it.

As investors, we attempt to organize our portfolios so that returns—convertible to real money—can flow to them in an uninterrupted way. Additionally, the higher and less volatile the flow of these returns, the better the quality of our lifestyles—that is, if we equate enhanced wealth with a better lifestyle. But the key term in this comparison is uninterrupted. We don’t really care how our returns get to us—just that they get to us. So when it comes to building a responsible investment portfolio, the mandate from the outset must be to mitigate the potential for the flow of returns to be interrupted—to lessen the risk of not having enough at any one time, to minimize the volatility of delivery, to maximize the amount delivered.

Interruption, as one well-known BTU carrier explains it, can be disastrous.

The term diversification has become synonymous with investing. It simply refers to the practice of purchasing many different types of assets across many industries and countries as a sure way of reducing risk within a portfolio. Being undiversified, on the other hand, can be a formula for failure.

The Trans-Alaska Pipeline describes this very well.

Basically, this pipeline is an 800-mile tube that moves a commodity from Point A to Point B, from Alaska’s North Slope to the state’s southern Port of Valdez. And the process involves risk—namely, supply has been vulnerable to disruption. For instance, an October 4, 2001, an intoxicated man shot a hole through the pipeline with his .338 caliber rifle, creating a “geyser” that spit 260,000 gallons of crude oil onto the tundra. The pipeline had been built to withstand many shocks—among them earthquakes and even the occasional errant rifle shot—but that October, all it took was one well-placed bullet to put it out of service for a long three days.^[3]

At the time, the pipeline accounted for 17 percent of domestic oil production, so the disruption was not insignificant in relation to the domestic portion of the U.S. oil “portfolio.” However, that portfolio also has a very large international component, famously (or infamously) fed by the OPEC nations, among several other oil-endowed countries. Thus, back in 2001, the Alaska pipeline disruption was but a blip inside the total oil portfolio of the United States. However, had the U.S. been dependent on Alaska oil—that is, had the U.S. oil portfolio been highly undiversified—a three-day disruption would have been catastrophic. The investing equivalent might be a portfolio built of shares of one stock, or a group of stocks in one industry that originate from one location. (As discussed in previous chapters, the latter tend to move in unison and are highly susceptible to negative local shocks.)

Politicians have long discussed the need for America to reduce its dependency on foreign oil, but the Alaska incident makes a slightly different point. To employ the cliché, it is never good to put all your eggs in one basket.

Two questions, or themes, arise out of this. First, how do investors build truly diversified portfolios, ones that will best connect to the various sources of returns while mitigating the effects of those adverse shocks—those random-bullet or wear-and-tear corruptions—that will interrupt the flow of those returns? Second, how can investors adjust their portfolios when adverse shocks threaten to puncture their return-carrying pipelines?

This latter question regards the central theme of this book; answering it is a lifetime story, whereby investors adjust to the macroeconomic events that cause predictable shifts in the return performance of the various asset classes. The former question addresses the starting point to this process: To capture returns in a responsible manner, each investor must construct a portfolio that connects to several of the various return-generating sources.

Elementary? Yes. But you might be surprised by the number of investors who get this initial step wrong. Looking up at a stock board, long-term investors should never really have moments when they scream “Argh!” and begin pulling out their hair, moments when a single “bullet” has interrupted the flow of their returns. A well-diversified portfolio protects against such events.

To extend the pipeline analogy, the well-diversified portfolio that seeks long-term gains must be built of many pipelines that connect to several alternative sources of returns. These sources are our fuels—from the single stock to the specific asset class—while those pipelines are our investment strategies. A portfolio built in this manner not only attains diversification—and, hence a reduction in the chance that the flow of returns will be interrupted—but also has the unique capability to maximize the flow of returns, which I believe is possible (and probable) by switching between investment strategies at the appropriate times.

The numerous and distinct pipelines to our investment returns are attached to varying levels of risk and, hence, different levels of potential disruption. Importantly, above a certain level of return flow, the higher the potential rate of flow is, the greater the likelihood of disruption is.

Modern financial advisors understand this well, and for the benefit of clients, they often map out all the possible combinations of return-carrying pipelines that can be positioned within a portfolio. In doing so, they come up with what they deem to be the most efficient tradeoff between the potential flow of returns and the potential disruptions. They call this compromise the efficient frontier. Specifically, financial advisors choose a point that represents the tradeoff between return flow and return disruption, personalizing this decision by weighing the costs associated with disruption and the marginal benefits of the higher flow of returns. In the end, they present their clients with an efficient path to their investment goals over time.

This is an efficient process. But to understand how a thing functions in the best of times, we often need to reflect on how it performed during the worst of times. Energy narrates the diversification story very well, but it does so particularly well in the context of the 1970s. At few times in American history has the free flow of energy been more at risk.

In his television address of April 18, 1977, President Jimmy Carter, outfitted in his trademark cardigan sweater, told the nation that the world was running out of oil. He said the call of the moment was akin to a “moral equivalent of war” and said that disaster would ensue if Americans did not alter their energy-consuming ways dramatically. To the economist, it was clear that Carter perceived a consumption problem and thus suggested a consumption solution. To most everyone else, Carter’s message was nearly equal to the one we now attribute to President George W. Bush: Americans were “addicted to oil.”

But by 1977, as anyone who sat in a gas line during that decade can attest, Americans were all too familiar with the rhetoric of energy-crisis wartime.^[4]

Oil, among other fuels, was a highly regulated commodity in the U.S. in the 1970s, subject to strict price caps, or ceilings. In economist terms, price ceilings inevitably lead to shortages because they lower the incentive to produce the goods that are capped. Put another way, there’s little motivation for companies to chase profits that do not exist. As the demand for a commodity increases in this environment, the ceiling becomes binding and no supply is forthcoming from the regulated suppliers. The only way for incremental demand to be satisfied, or the shortage to be resolved, is for another supplier to be willing and able to produce.

In the 1970s, energy-price controls in the U.S. restricted domestic supply and inadvertently diverted all the incremental supply to that willing and able supplier: the foreign producer and, in particular, OPEC. As OPEC became aware of the supply-and-demand realities in the U.S., it figured correctly that there would be no alternative to OPEC oil in the short run. The U.S. would simply have to pay up or do without the oil.

Once again, this is a single-pipeline story. For instance, oil makes gas, which makes cars go. When there is a major oil shortage and, hence, a major gasoline shortage, drivers can either not drive or deal with the realities at the pump (long lines, high prices, etc.). But the plot thickens when we move to the home, business, and industrial fronts.

Back in the 1970s, oil came by way of the oil truck (as it still does), which fed the fuel into the storage tanks that attached to the individual boilers in the basements of American homes and businesses. As mentioned, domestically produced oil was a price-capped commodity, which only made a scarce commodity that much scarcer. Meanwhile, natural gas was fed via pipelines from the wellhead source to distribution plants, which then sent the gas via smaller pipelines to individual properties. (This is still the case.) But the free flow of natural gas was inhibited by artificially low price ceilings on sales of the fuel across state lines. To make matters worse, the artificially low price created demand in excess of the forthcoming supply.

As a result, to “ration” the available supply, the government set moratoriums on the number of homes and businesses that could “hook up” to natural-gas lines. By the mid-1970s, for example, there were restrictions on residential hookups in nearly half of all gas-utility franchise areas. Such non-price-rationing schemes, in the name of conservation, blocked an alternative source of energy from feeding homes, businesses, and factories alike.

However, none of this meant consumer demand for energy had lessened.

Demand would also be met, if not directly via the fuel pipeline that fed the individual boiler, then indirectly via the generation of electricity, a prepackaged and highly versatile source of power.

Coal, oil, natural gas, hydropower, and nuclear power—a menu not available to any one end consumer—could all feed the generating facilities. On the demand side of the equation, this meant risk reduction: Several fuels could now produce the same energy for the end consumer. It also meant guaranteed service at a competitive price: Unlike the end consumer, the electricity facilities could burn multiple fuels, could arbitrage the costs of generating power across fuels, and were freed from the curse of being shut out of any one fuel market. If they could not buy Fuel A, they would simply shift to Fuel B. And unlike the vast majority of end consumers, they could burn coal, an abundant fuel limited to only the largest industrial generators and boilers.

The ultimate result of all this? Between 1970 and 1980, consumption of electricity increased from 24 percent to 31 percent of the nation’s total (see Table 8.1).

However, energy demand—broken down by the transportation, residential/commercial, and industrial sectors—held relatively constant throughout the period (see Table 8.2). This is a central point: Although regulations altered 1) the way consumers obtained their energy, 2) the prices paid for that energy, and 3) the methods of delivering that energy, they did not in any significant way alter the amount of energy being consumed.

In the end, by buying electricity, consumers let the electricity-generating facilities worry about the availability of the different fuels. Consumers wanted their power, just as the electric utilities wanted to deliver it to them. In each case, pragmatic pursuits of an end result won the day.

Pragmatism accounted for, this shock study elevates in usefulness because of the near one-to-one relationship between mankind’s acquisition of energy and the investor return.

The case can be made, however, that we are much more efficient in our pursuit of energy than we are of the return.

I could build more parallels between energy and the return. And I make several of the parallels drawn here more specific in the next chapter, when we discuss the several ways modern investors go about obtaining their returns. But you get the idea. When it comes to getting what we want, in the amount we want, and when we want it, we tend to act very pragmatically—substituting different means to attain our ends. But again, investors overall have a lot to learn from the typical consumer of energy.

The next time a politician says you are “addicted to oil,” I hope you will understand this accusation to be patently false. Indeed, as automotive technology advances, “addicted to hydrogen” or “addicted to ethanol” might enter the political lexicon. But these statements also will ring artificial. When it comes to energy, consumers have proven that the ends matter, not the means.

Truth be told, however, investors too often show an allegiance to the means.

Imagine, for instance, that someone said American investors were “addicted to large-caps” or “addicted to ETFs” or “addicted to bonds” or addicted to “Microsoft.” At this point, I would hope such accusations would sound bizarre to you. If anything, we are, or should be, addicted to the return. However, in each of these fictional accusations, there is some truth. In the pursuit of getting what we want, in the amount we want, and when we want it, we often make compromises. Some of us do so willingly, while others of us do so because we don’t know any better.

From here, we shift our study of the return from the theoretical to the practical level. Few investors act alike, but most fall into distinct behavioral groups. Which group is for you? In the next chapter, I steer you toward the optimal answer.