If you have some money you decide not to spend, you preferably want it to grow so you can buy the same goods – or even more – any time in the future. Yet, you don’t know what the future may bring. The value of your investment might increase or decrease over time, and most likely, it will do both along the way.
How then do you balance the uncertainty of all future scenarios for your investment against the certainty of a (low yield) savings account?
Precisely this question has been the subject of much research and debate.
Two Nobel Prize-winning lines of thought are at the heart of investing. One adheres to the rules of rationality while the other adds humanity to the picture. In our experience, only a combination of both allows us to make investment decisions that stand the test of time.
Let’s start with traditionally the most overlooked but also the most potent dimension: humanity.
Here the question is to know what you will feel once your investment changes value. There will be ups and downs. And, the more you check your position, the more downs there will be, even if the long term performance is positive. How will you react? How do you balance interim gains and losses? How tempted are you to shift gear when the going gets tough, or when markets are doing remarkably well? Knowing how you react to short term changes determines what the outcome of your investment might be in the long run.
That brings us to the second dimension. Knowing how you react to short term changes determines the range of possible outcomes in the long run. How do you deal with the uncertainty embedded in this future outlook? How do you cope with the fact that the future realized performance is not known today? How do you balance the ambition of your long term return expectation with the risk of not reaching your goal?
Like any positioning system, it takes two coordinates to locate yourself in the world of investing.
You need both elements defined to have a well-motivated investment decision. Only then are you ready to build a tailored portfolio that will be future-proof. A portfolio you will stick to because it reflects who you are.
What rational investors should do
The textbook assumption on rational decision making states the following: people prefer more to less and dislike risk. This almost trivial statement gives rise to a convenient framework. When looking at the future, investments have an expected — average — return, but people realize that investing comes with some risk. The risk is that actual performance over time will deviate from the initial expectations.
People prefer more to less but dislike risk.
– H. Markowitz
Of course, you prefer more return to less. Also, your rational preference between two alternatives with the same expected return should have the lowest risk.
The framework neatly captures reward and risk as the balance between the average value and the dispersion of outcome. Its applications are numerous. Think about investor risk profiles, risk profile portfolios, risk-adjusted performance measures,… This framework has shaped the asset management industry for years. Although developed in the ’40s and ‘50s of the previous century, the model is still commonly referred to as “modern” portfolio theory.
What real investors do
Now, think about what modern portfolio theory implies. Do people really switch off their emotions once they enter an investment? Does the investor submit to temporary fluctuations just like that? Is the investor patient to observe that, in the long term, actual performance indeed differs from its expected value? Most likely not.
Losses loom larger than gains.
– A. Tversky & D. Kahneman
While experiencing the evolution of their portfolio, most people do not treat interim gains and losses equally. Also, in everyday life, many people take more effort to prevent a loss than pursue a gain.
In the particular case pictured above, the future unfolds within the range of anticipated possibilities. Fine. But even then, it turns out to be a bumpy road. Will the investor stick to the plan at all times? There will undoubtedly be some tension along the way. That’s where humanity comes into play.
In the long term we are all dead, unless the short term kills you first.
– A. Lo on J.M. Keynes
People are not closing their eyes until their investment horizon is reached. Markets are falling? Investors sell off some positions. Prospects are improving again? Investors gradually rebuild their positions, especially once the markets have completely recovered. Market studies provide ample evidence that many people act like this.
That is why we advocate a combination of both dimensions in the decision-making process.
How to integrate in the investment process?
- Check investor emotionality to balance of interim gains and losses
- Picture future outlook to balance long term expected performance and uncertainty
The investor’s emotionality comes first. What proportion of interim gains and losses will make the investor stick to the plan? The aim is to enter into a long term relationship, right? The first step, therefore, pictures how the investor balances interim gains and losses in relative terms. For the population as a whole, losses typically weigh twice as high as gains. The exact balance may be different for every one of us. And that’s what we need to assess.
Next, we want to know what the investor can cope with. Now we talk about the absolute value of performances and their fluctuation. Assuming that losses indeed loom twice as large as gains, how do these gains and losses look in absolute numbers? Here again, people may differ. This second step has a crucial impact on the future outlook and the long term rational balance of average return and dispersion.
In combination, the short and long term view mold your investment proposal to the investor’s preferences. You will make offers the client won’t refuse and will stick to even during crises.
