Newton's First Law (of Finance)

Engineers, especially PEs, have a deep understanding of forces.

Every project requires the engineer to understand the forces at play and design a system/structure that accounts for those forces while still delivering a project that meets the intended use.

If you are an engineer, you might analyze forces all the time. But have you ever considered the forces acting on the assets in your portfolio or in your personal finances?

If not, I would like to pose a question:

How can you know how to design your portfolio or your financial plan if you don't understand the underlying forces at play?

I decided to start this weekly newsletter to help you answer that very question.

The first series of articles will look at portfolio construction through the lens of Newton's laws of motion.

First up is Newton’s First Law.

Imagine your portfolio is a free body floating along an X-Y graph. The rate of movement in the x direction is fixed. That is of course unless you have a time machine. I seem to have misplaced mine.

Since we can't do much about the rate of movement in the X direction, the rate of movement in the Y direction is the big question!

As with Newton's First Law, we need to understand that our assets have a current state of motion. In other words, they have an initial velocity in the Y direction which we can call the expected rate of return. The asset will maintain this rate of return unless a force acts upon the asset.

When you hold cash, your portfolio is effectively immune to external forces. You know your actual return will be equal to your expected return. While this certainty is nice, it doesn't pay to only hold cash over the long run. In order to maximize future purchasing power, you generally want to own riskier assets that tend to outpace cash over the long run.

If you hold a risky asset like a stock or bond, your expected return is the risk-free rate (cash) plus the risk premium you expect to receive for exposing yourself to a risk factor (e.g. market, term, credit, etc.). The image below shows this breakdown.

Based on this logic, the expected return of a risky asset is higher than that of cash. If no other forces act on the asset during the holding period, you can expect to realize this expected return over time. The easiest way to understand this is to think about a bond.

Let’s assume that cash is paying 3% and a 10-year treasury bond is paying 5%. The expected return of the bond is 3% from the risk-free rate and an additional 2% for the term risk you are taking on by holding a longer duration bond.

If you hold this bond to maturity, you will get exactly 5% return per year on your initial investment.

This, of course, is an oversimplification to explain a point. In reality, if you own risky assets, you are exposing yourself to the forces that causes these assets to constantly bounce up and down in value over time.

There is no way to eliminate this volatility from your portfolio. It is a natural result of investing in risky assets.

But what if you could better understand the forces that are pushing and pulling on the assets in your portfolio and design something that can better balance out the various forces?

At the top of this article, I described how engineers have to understand the forces at play and design a system/structure that accounts for those forces while still delivering a project that meets the intended use.

Apply this statement to your portfolio. What is the intended use of your portfolio and what are the forces that we need to overcome in order to meet or exceed the intended use? What if we could find a better equilibrium of these forces in order to make our investing journey a little more enjoyable?

We will begin to define these forces next week when we look at Newton’s Second Law.