A Disordered Mind Makes Mutual Fund Salad

Good portfolios are parsimonious portfolios. They accomplish their objectives with as few moving parts as possible. This is not simplicity, per se. It is economy of effort.

Parsimony is a difficult thing in the financial world. There are lots of ways to skin the proverbial cat. There is constant temptation to tinker at the margins. Armies of salespeople are paid handsomely to convince you to fiddle with things.

If your mind is disordered and cluttered, you will manifest that in your physical environment. Random stuff will accumulate. It will become difficult to distinguish value from kitsch.

Eliminating clutter takes energy. A disordered mind neither uses nor generates energy efficiently. It does not properly recharge over time. Over time, energy reserves deplete. Eventually they will be exhausted. This is not sustainable. We all know this on an instinctive level. It is why burnout follows a particular pattern. The burnout source consumes so much energy there is nothing left for anything other than managing that stress. We cope by shutting off non-essential functions and activities. It is a desperate, last ditch strategy to preserve a dwindling energy reserve.

Cultivating parsimony is hard work. This is obvious to anyone who writes. People who do not write tend to think the hard thing is generating output. Output is certainly a matter of consistency and discipline. But provided you put in the time, it’s not especially difficult to vomit up volumes of material. The trick is distilling that first draft puke into something worth reading. For every word I’ve posted publicly, I’ve probably trashed at least ten words of raw output. Maybe a hundred.

Parsimonious portfolios remain focused on targeting specific sources of risk and return. The antithesis of parsimony in portfolio construction is what some call “mutual fund salad.” A mutual fund salad is a giant bowl of positions tossed together.

Mmm, a taste of everything! It’s diversified!

Mutual fund salads are often sold. They are rarely bought. They result from clever salespeople convincing well-meaning investors to add little bits and baubles to portfolios. Sometimes this is a “new” asset class. Other times it’s a tactical trade. Often it’s stuff people like to own to feel smart and special that they can brag about at parties.

In my case, I became enamored of little satellite ideas to the point where they began to swamp my portfolio. This was a direct product of my professional burnout. I may not be able to implement any ideas and work, but no one’s going to stop me from doing what I want in my PA! My disordered mind had manifested in my finances.

All portfolios are subject to a certain degree of entropy over time. They require regular pruning to avoid degenerating into mutual fund salad. An investor in a disordered state of mind cannot prune effectively. She may not be able to summon the activation energy to prune at all. For me, burnout was the culprit. It also happens when someone invests on tilt.

“Tilt” is a gambling term. When you are on tilt you are playing emotionally. Usually too aggressively. In case it isn’t immediately obvious, you should never, ever gamble on tilt.

The archetypical tilted investor is the professional money manager who eats a big drawdown and tries to make it back quickly, with aggressive bets. This is no different from “putting it all on black” at the roulette table. You would be surprised (on second thought, maybe not) how many allegedly sophisticated investment operations are just elaborate martingale systems. You can also get tilted just by watching other people get rich. Particularly if they’re getting rich in stupid ways. Back in the day, when Druckenmiller lost a bundle on dot com stocks, he was playing on tilt (he also was self-aware enough to acknowledge it afterward).

This happens on the risk-averse end of the spectrum, too. Sometimes, due to bad experiences or personal biases, investors cannot bring themselves to put on an appropriate level of risk. I’ve seen this happen after significant mistakes (which is understandable). I’ve also seen it happen when an investor anchors heavily on his priors. These priors can be rooted in past history or finance theory. This is, perhaps, a less dangerous form of tilt than being hyper aggro. Scared money usually just sits in cash. So it’s not going to zero. But it is subject to significant opportunity costs over time. “Scared money don’t make money,” as they say.

This is all just a long-winded way of saying your emotional state can have a significant impact on your investment decision-making. On its face that’s a trivial observation. Doesn’t even qualify as insight. There are probably 10,000 finance writers typing essentially that same sentence right now. It’s behavioral finance 101 material. Axiomatic.

Yet, I do think it’s easy for more sophisticated investors to lull themselves into a false sense of security around susceptibility to emotional swings and states of mind. We’ve done the academic coursework. We know the pitfalls. Surely we’re smarter than that?