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.