Justifying Poor Investment Choices
When presented with evidence that investment B is inferior to investment A, a common human reaction is to decide to invest less money in investment B rather than none at all. This kind of thinking may be what is behind some investment choices.
To illustrate what I mean, imagine that you’re playing a game where several decks of cards are shuffled and then you have to guess whether each of the top 16 cards is a spade or not before it is turned over. When asked what the best strategy is, a common response is to choose “not spade” 3/4 of the time and “spade” 1/4 of the time.
However, the strategy that maximizes the number of correct guesses is to guess “not spade” every time. The “not spade” strategy is expected to be right about 12 out of 16 guesses. The mixed strategy will guess “not spade” 12 times and get about 9 right, and will guess “spade” 4 times and get only one right, for a total expected number of right answers about 10 out of 16.
How does this relate to investing? We have many different justifications for allocating a small amount of our savings to investments we believe are inferior. For example, some advocate owning a small amount of gold. Gold has performed poorly over the long haul, but many people think they should have a little.
We are often told that it’s okay to invest the bulk of our savings in solid investments and allocate a small amount of “play money” to invest in dubious high-risk stocks. Others advise investing a small amount in some particular emerging market or market sector, but this makes little sense if we know nothing about that emerging market or market sector.
This idea of investing small amounts in dubious investments is often justified in the name of diversification among uncorrelated assets. This is a worthwhile goal to a point, but beyond a certain point, the benefits are minimal and do not compensate for the loss in expected return.
There can be good reasons for owning a variety of assets, but it should be based on serious thought rather than simply averaging out all the advice you hear.
To illustrate what I mean, imagine that you’re playing a game where several decks of cards are shuffled and then you have to guess whether each of the top 16 cards is a spade or not before it is turned over. When asked what the best strategy is, a common response is to choose “not spade” 3/4 of the time and “spade” 1/4 of the time.
However, the strategy that maximizes the number of correct guesses is to guess “not spade” every time. The “not spade” strategy is expected to be right about 12 out of 16 guesses. The mixed strategy will guess “not spade” 12 times and get about 9 right, and will guess “spade” 4 times and get only one right, for a total expected number of right answers about 10 out of 16.
How does this relate to investing? We have many different justifications for allocating a small amount of our savings to investments we believe are inferior. For example, some advocate owning a small amount of gold. Gold has performed poorly over the long haul, but many people think they should have a little.
We are often told that it’s okay to invest the bulk of our savings in solid investments and allocate a small amount of “play money” to invest in dubious high-risk stocks. Others advise investing a small amount in some particular emerging market or market sector, but this makes little sense if we know nothing about that emerging market or market sector.
This idea of investing small amounts in dubious investments is often justified in the name of diversification among uncorrelated assets. This is a worthwhile goal to a point, but beyond a certain point, the benefits are minimal and do not compensate for the loss in expected return.
There can be good reasons for owning a variety of assets, but it should be based on serious thought rather than simply averaging out all the advice you hear.
So are you advising me to divest from my significant holdings in United Buggy Whips? When Gasoline prices soar I will make a killing (is what I heard on TV from some guy).
ReplyDeleteI'll have to take this into consideration.
What about my holdings in Nortel?
Big Cajun Man: As long as you only have a small amount of money in United Buggy Whips and Nortel, you're doing fine :-)
ReplyDeleteI like how you took the non-spade analogy and applied it to investing. Interesting.
ReplyDeleteI see a lot of bloggers apply this rule - since it's hard to beat the market, attempt only to match the market with 100% index funds. Do not try to pick a spade by investing directly in common stock.
It's kind of like how Warren Buffett avoids investing in things he doesn't understand. By sticking to things he understands well, he's avoiding guessing on whole segments he finds less predictable.
If I were given the deck of cards, I'm sure I would guess spade about 25% of the time. Now that I know the odds, I might go with 100% non-spade. Of course, this game doesn't come up as often as its analogies do.
Gene: Thanks. I wasn't sure how clear this one was. If you spend any time in Las Vegas, games broadly similar to the spade game come up very frequently. Unfortunately, their payoffs always turn out to be a little less than you might hope.
ReplyDeleteGood post! I love your example of the deck of cards. It is amazing how people, including myself, make choices based on emotion (from what they hear) rather than logic and intellect!
ReplyDeleteThe problem with the spade analogy is there is no payback for picking the higher risk spade choice, so you should always pick non-spade. If you make guessing a spade correctly worth 4 points instead of 1, it becomes more interesting. How many long shots do you go for...
ReplyDeleteAnonymous: Actually the spade experiment is more than an analogy. It has been done in real experiments where the payoff is just 1:1 and people still pick spade sometimes. I agree that it can make sense to go for a long shot if it has the right payoff. Unfortunately, people too often go for long shots with poor payoffs.
ReplyDelete