Portfolio Optimization Errors

A friend of mine likes to save money by ordering items in the U.S. and driving across the border to pick them up.  The trouble with his claim of having saved $50 on some order is that he ignores his car costs and the value of his time.  This mistake of leaving out important considerations because they are hard to value accurately creeps up in many decisions.

A group of my golfer friends like to figure out whether to buy a golf membership or not.  If the membership is $2400 and an average round costs $40, they reason that they need to play 60 rounds to break even on a membership.  However, getting a membership gives access to regular social functions.  This social consideration could easily be worth a lot to some people, and could even be a negative for others.  It’s also valuable to be able to start playing when the weather is iffy without worrying about losing money if the round has to be abandoned.  Some members even play more often than they really want to so they can justify the cost of a membership.  It’s better to come up with a roughly correct answer that takes into account all important factors than it is to come up with an exact answer that leaves out relevant considerations.

Whenever I see someone declare something like “I calculated that REITs should be 18.5% of my portfolio,” it’s obvious that relevant factors have been ignored.  We can’t know the exact future distribution of asset class returns.  Any attempt to use mean-variance optimization or some other optimization technique necessarily ignores the fact that the future may not look exactly like the past.

There’s nothing wrong with using past returns as a guide to the future, but we also need to think through other possibilities.  We could have higher (or lower) inflation in the future than the average over some period of the past.  The four decade bull run in bonds could transition into a multi-decade bear market in bonds.  Tax rates could change.  Stocks could tank in a way we’ve never seen before.  We can’t optimize for all these possibilities, but we can try to choose a plan where we’ll come out okay across all reasonably likely outcomes.  Thinking this way is very different from using guessed correlation figures to calculate perfect portfolio percentages.

Another mistake I see among those seeking the perfect portfolio is frequent tweaking to take into account new information.  These investors seem to think each portfolio change they make will be the last because their portfolio is finally perfect.  But then they learn something new that leads to more changes.  For some, all the adjustments become a form of buy high and sell low as they constantly shift toward whichever asset performed well recently and has a good story.

An area where I had to let go of trying to be perfect was in my asset location choices.  I have a set of rules for which types of accounts hold which asset classes.  For example, I try not to hold any fixed income in my RRSPs.  However, when it comes time to rebalance my portfolio, sometimes it’s just easier to buy some short-term bonds in my RRSP.  I still mostly stick to my asset location rules, but I’m not strict about it.  Any losses I suffer from not having a perfect portfolio are small compared to the peace of mind that comes from not worrying about small things.  This frees me to think about more important issues, like the possibility that the U.S. might change inheritance tax rules for Canadians who hold U.S. assets.

In summary, it’s much better to think about all the important factors in any choice, including those that are hard to quantify, than it is to calculate the easy-to-quantify factors to three or four decimal places.