Different Priorities, Different Portfolios

So I pushed out my big behavioral finance/investing values post last week only to discover today that Morgan Housel is riffing on the same themes. He writes:

[W]e rarely recognize that most investment debates – debates that literally make markets – are just a reflection of people making different decisions not because they disagree with each other, but because they view investing with a different set of priorities.

If you’re trying to maximize risk-adjusted returns you have no idea why someone would buy a 10-year Treasury bond with a 2% interest rate. But the investment probably makes perfect sense to Daniel Kahneman. Paying off your mortgage with a 3% tax-deductible interest rate is probably crazy on a spreadsheet but might be the right move if it helps you sleep at night. Trading 3X leveraged inverse ETFs is financial suicide for some and a cool game for others. Long-term investors who criticize day traders bet on football games because it’s fun. People who scream at you for over-allocating into REITS buy six-bathroom homes for their four-person family. The flip side of Daniel Kahneman is the billionaire who risks his valuable reputation to gain money he doesn’t need. Have you been on Twitter? People see the world differently.

Two rational people the same age with the same finances may come to totally different conclusions about what’s right for them, just as two people with the same cancer can pick radically different treatments. And just as medical textbooks can’t summarize those decisions, finance textbooks can’t either.

This isn’t just about differences in risk tolerance.

People who work in finance underestimate that watching markets go up and down isn’t intellectually stimulating for most regular people. It’s a burden. And even if they can technically stomach investment risk, the added complexity robs bandwidth from other stuff they’d rather be doing. The opposite is true. Claiming your investment product is entertaining is usually the refuge of those who can’t point to performance. But it’s crazy to assume that many people don’t find investing incredibly entertaining – so much so that they rationally do nutty stuff regardless of what it does to their returns.

Everyone giving investing advice – or even just sharing investing opinions – should keep top of mind how emotional money is and how different people are. If the appropriate path of cancer treatments isn’t universal, man, don’t pretend like your bond strategy is appropriate for everyone, even when it aligns with their time horizon and net worth.

Here are some areas where I think personal values and priorities will play a significant role in your view of optimal portfolio construction:

Definition of risk. Do you define risk as volatility (“prices going up and down a lot”), or as permanent impairment of capital (“realizing losses in real dollar terms”)?

Definition of performance. Are you focused on absolute performance (“I want to compound my capital at 10% annually”) or performance relative to a benchmark index (“I want to outperform the S&P 500”)?

Tax sensitivity. Are you someone who will spend $1.05 to save $1.00 in taxes based on “the principle of the thing?” Or are taxes just something you have to deal with if you want to make money?

People who use volatility as their risk measure, focus on relative performance and are extremely tax sensitive tend to gravitate toward passive investing strategies. Those who define risk as permanent impairment of capital, focus on absolute performance and are less tax sensitive might favor a more active approach.

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