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HARRY MARKOWITZ, the Nobel Prize-winning economist who passed away recently, invented a new approach to investing. Known as modern portfolio theory, it offered investors, for the first time, a logical approach to building portfolios. How much should you hold in stocks vs. bonds? Markowitz could tell you precisely.
But Markowitz also knew math wasn’t the only driver of investment decisions. In a frequently cited interview, Markowitz recalled how he decided what to hold in his own retirement plan early in his career. “I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it,” he said. “So, I split my contributions 50-50 between bonds and equities.” In other words, Markowitz set aside the formulas and opted for a solution that simply felt right.
In later years, Markowitz said he did take a more rigorous approach. But he nonetheless found common ground quite often with behavioral economists—those who take a distinctly non-quantitative approach to investing. Markowitz happily collaborated, for example, with fellow economist Meir Statman on a 2010 paper.
In it, they worked to reconcile modern portfolio theory with popular behavioral theories. Their conclusion: Consumers try to be rational, but only after deciding on their personal goals—which are rarely driven strictly by the numbers. In other words, the desire to maximize returns or to minimize risk, which are the two pillars of modern portfolio theory, aren’t the only factors that motivate investors.
What does motivate investors? James O’Shaughnessy is the founder of a quantitative investment firm. In a recent write-up, he reflected on what he’s learned about investors through a long and successful career. One paper he found particularly valuable: “Why Do Individuals Exhibit Investment Biases?” To answer this question, the authors identified two factors.
One was genetics. Some of us are simply born with a greater or lesser tolerance for risk. That explains almost half of decision-making. The remainder, the authors concluded, is accounted for by each individual’s personal experience with investment markets. I’ve certainly found this to be true. We are all shaped by our experiences. In my work, I’ve observed a number of other factors as well, including:
1. Salespeople. If you’ve ever been on the receiving end of a pitch from a life insurance salesperson, you know how easy it is to be affected by salespeople’s ability to tap into our fears. Even when we know what they’re trying to do, they can be very convincing.
2. Self-image. It’s not just salespeople. I’ve referred in the past to what I call the brother-in-law effect. Much as we wish it weren’t the case, the opinions of friends and neighbors do affect spending decisions.
3. Status. Look at the data on private equity and hedge funds, and you’ll find that, on average, they haven’t been the best investments. So why do individual investors continue pouring money in? Meir Statman suggests one theory: Because these funds often have very high minimums, it’s a sort of status symbol to be invested in funds like this.
4. The leaderboard. Hedge fund managers regularly rank among the highest-paid and wealthiest Americans. At a certain point, you might wonder why they keep working. If someone has already accumulated $500 million, is there really a need to get to $600 million? From a financial standpoint, no. But if it means you’ll pull ahead of your neighbors in the wealth rankings, then the answer very well might be yes.
5. Debt. One of the most commonly asked questions of investment advisors is: If I can afford to pay off my mortgage early, should I? Especially for those with very low mortgage rates, it might seem irrational to pay down this debt more quickly than is required. But that ignores an important reality: Some people are simply more comfortable with debt than others. Many derive such satisfaction from being debt-free that they don’t care what the math says.
6. Values. Earlier in my career, I worked at a firm that, as a policy, didn’t invest in tobacco, firearms or gambling-related stocks. Not once did I hear a client ask how much better or worse they would have done if they’d had those companies in their portfolio. Indeed, even if these investors were earning less, I suspect they would’ve viewed that as a small price to pay for being able to feel good about their investments.
7. Religion. At that same firm, we also managed portfolios for a number of religious groups. Their portfolios were structured to exclude additional companies considered objectionable. Especially in their case, I doubt they ever worried how many basis points they were giving up to be able to align their investments with their principles.
8. Fun. If you think investing isn’t fun, tell that to someone who’s “hodling” bitcoin. Or ask why Robinhood used to rain confetti down the screen after an investor made a trade. In my view, investing shouldn’t be used as entertainment. It’s certainly not what modern portfolio theory would recommend. But just like those who invest according to their values, I doubt these investors worry how their returns compare to standard benchmarks. After all, where’s the fun in an S&P 500-index fund?
9. Fear. Meir Statman notes that consumers often make decisions that—strictly according to the math—are suboptimal. But behind them lies a powerful motivator: Especially for those who had to work their way up the ladder, an overriding goal is to avoid ever going back.
10. Rare disasters. Fear takes many forms. Economist James Choi notes that many investors live in fear of “rare disasters”—a repeat of the 1930s, for example, when the stock market sank 90%. The challenge, Choi says, is that it’s very difficult to combat these fears because there is, by definition, so little data on rare events. As a result, many live in fear that “the big one” is always right around the corner.
The lesson? I’ve noted before that there are two answers to every financial question: what the calculator says—and how you feel about it. If you ever find yourself feeling conflicted between these two answers, the most important thing is to understand why you wish to go in a particular direction. There are, as we’ve seen, a long list of reasons we might choose to make one choice or another. As long as you feel like a given choice makes sense to you, and as long as you can afford it, no one should tell you that your decision isn’t the right one.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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There is a benefit to paying off your mortgage that I don’t hear discussed. By carrying a mortgage you have increased your overall risk which requires you to offset with additional reserves. This reduces the amount of your risk assets and their corresponding return.
We have gone back and forth about paying down our mortgage, which is at the very low rate we refinanced to in 2020. Even though we’re close to retirement, I don’t think we’re going to make accelerated payments at this point.
We’ll both have pensions and Social Security, all with built-in COLAs, when we retire. We’ll easily be able to afford the mortgage payment. But probably the biggest issue, and it’s psychological, is that we spent a couple of decades with very little liquid savings but tons of home equity. When we sold our home in 2019 and bought a new condo, we made about a 25% down payment, put aside cash to furnish and decorate the new place, and parked the rest in a cash account. When the pandemic hit eight months after we moved, I had a lot more peace of mind knowing that we had a hefty cash cushion. I don’t want to give that up and have a big chunk of net worth tied up in our home—and we might sell and move again, anyway.
I am one of those who paid off their mortgage early despite it having a 2 5/8 interest rate. The feeling each month of being debt free is absolutely worth it.
Thanks, Adam—all excellent points.
I tend to be overweight in cash, and while I know this isn’t optimal investment behavior, it does wonders for my state of mind and sleep at night. In recent months, getting 5% virtually risk free on that cash has been icing on the cake.
I feel similarly Andrew, although have been thinking about moving some of that cash to a short term Treasury fund, especially as the Fed seems to be slowing rate hikes.
Thanks Adam for the article.
Michael, that has some appeal, especially now (or soon) for the reason you cite. I’ll note that both Jonathan and Adam have written that short term Treasurys/funds are a large part of their bond allocation.
I appreciate your contrasting “what the calculator says and how you feel about it.” A realist knows that if you ignore those feelings you may later be prone to making a risky move at just the wrong time. It seems plausible that learning from experience and reading, your feeling about various investing options may evolve. The question whether “one’s goal is to get rich or to not die poor”, as discussed by Jonathan, Bill Bernstein and others ought to drive your investing strategy. An honest answer to this question, for me and I suspect many others, may vary, depending on my mood that day, recent events in the world and the market, and a myriad other factors I may not even be conscious of. I guess my answer is somewhere in the middle. May not be rational, but it is honest. Thanks for yet another great article Adam!
the most important thing is to understand why you wish to go in a particular direction
Good advice for making many decisions, not just financial ones. I switched jobs a year ago this week. When I first thought about switching, my focus was on finances. Staying would have me reach Rule of 80 in 2025, at which point I could retire and draw pension, while leaving meant waiting until 2028 to withdraw pension. Financially, staying made sense but I couldn’t shake the desire to look elsewhere.
I took a week’s vacation, relaxed, and figured out why leaving that job appealed. I like working. I have no plan for retirement, so it sounds rather boring. But while I like working overall, we’d had a major leadership change within the previous year, and I had concerns about the new leadership team’s ethics.
Once I figured why changing jobs sounded appealing, it was easy to decide to go on the job market. I could still retire in 2025, but I no longer wake up dreaming of the day I can escape my workplace. I’m enjoying my work again, proving that I made the right decision for me.
Spot on, Adam.
#8 Fun. I confess that I often login just to see the dividends that arrived while I was sleeping. It’s fun.