Math vs. Emotion

Adam M. Grossman

YOU’VE NO DOUBT heard this before: Asset allocation is the single most important investment decision. If you have the right mix of stocks, bonds, cash and maybe real estate, you sharply increase your chances of success. 

But how do you pick the right mix? There are rules of thumb based on age, there’s a statistical approach called Modern Portfolio Theory, there are risk tolerance questionnaires and there are cash flow-based approaches. Each delivers a different answer—because each emphasizes different factors.

What if the answers differ dramatically? It’s not uncommon for a strictly mathematical analysis to result in an asset allocation of 100% stocks. Meanwhile, if that same person were to fill out a more qualitative risk questionnaire, the result might be far more conservative.

What should you do if the math says one thing but your stomach says another? Should math trump emotion—or the other way around? As you wrestle with this question, here are five considerations:

1. All math involves assumptions. If the math says your portfolio can afford maximum risk, ask yourself what assumptions underlie that calculation. In particular, what assumptions are being made about the stock market? If you look back at U.S. stock market history, downturns generally result in losses of 20% to 50% and last two to four years. But notice that I said “generally.” During the Great Depression of the 1930s, the market dropped more than 80% and didn’t fully recover for more than a decade.

2. Just because something hasn’t happened recently—or hasn’t happened here—doesn’t mean it can’t happen. To be sure, the Great Depression was a long time ago, and the stock market now has systems in place to help prevent a crash of similar proportions. But you shouldn’t write off the 1929 crash as ancient history.

Consider Japan. In 1989, it was on top of the world. Its economy and stock market were soaring. But over the subsequent two decades, the Japanese market declined more than 80%. Even today, nearly 30 years later, the Nikkei index stands almost 50% below its peak—a sober reminder that unexpected things can happen.

3. Your needs might change. Suppose you do the math and determine that your asset allocation is robust, because you have five years of spending money set aside in bonds and cash. In theory, that would carry you through a typical market downturn (though not the Great Depression). But what if something happened—a health issue, for example—and your expenses increased? These kinds of things are impossible to predict, but I think it makes sense to allow for the unexpected when structuring your finances.

4. You might not know your true tolerance for risk. If you haven’t lived through a 50% market downturn like the U.S. market experienced in 2000-02 and 2007-09, you might not have an appreciation for what it’s like. More to the point, you may not know how you’ll react. If you haven’t yet lived through a true bear market, when all the news is relentlessly bad, you might want a more moderate asset allocation than the math suggests.

5. It might be unnecessary. One day last summer, I found myself speeding through upstate New York. I had to get to a meeting. But when I looked at the clock, I realized I had plenty of time. I was racing for no reason and risking an expensive run-in with the New York State Police, so I immediately slowed down. If you’ve built up substantial savings, you may be in the same position—taking lots of stock market risk when it’s no longer necessary. If you have the risk dial set to 10, ask yourself whether you’re swinging for the fences, even though you’ve already won the game.

Adam M. Grossman’s previous articles include Don’t Bank on ItDanger Ahead and Know Doubt. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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