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Brains, Gains, and Losses

I recently finished reading Nassim Nicholas Taleb’s Fooled by Randomness. (Highly recommend it, in case you’re curious.)

At one point in the book, Taleb mentions that, when looking at the outcome of a transaction, our brains are set up to react primarily to whether we’ve incurred a gain or loss–not, that is, to the size of the gain/loss we’ve incurred.

Quick note: I’m certainly not a medical professional, nor is Taleb. So please keep in mind that this information is now at least 2 degrees of separation away from its source.

If the claim is true, it would certainly have some fascinating implications for investing. For example…

We prefer frequent gains to big ones.

And more to the point, we’d most enjoy infrequent losses.

Imagine that you’re given the choice between:

  • a portfolio that earns a steady 6% return per year, or
  • a portfolio that goes up in 2/3 years, down in 1/3, and earns an effective annual 12% return.

Our brains are hardwired to prefer the first portfolio, despite the fact that our wallets would prefer the second.

Essentially, this gets right at the heart of what I was trying to say a while back: A lack of volatility provides us with a mental/emotional benefit that is real and valuable (though not measurable). And that, in my opinion, is the primary (and perhaps only) reason for including non-equity investments in a portfolio that still has decades to go before liquidation.

Your thoughts?

What do you think? Is that true? Or is there some other reason to allocate a meaningful percentage of a decades-until-liquidation portfolio toward fixed income investments?

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Comments

  1. Sure I believe it.

    That’s why so many foolish investors prefer to take profits quickly and hold losses forever.

    They believe that if the loss has not been realized then it’s doesn’t count.

  2. You ask some tough fundamental questions here. I agree with the mentality thing.

    But your real question is “Why own anything other than stocks if you’re 20 years or more from requiring the money?”

    I could write some really long thoughts here, but maybe I’ll take a different tack and just keep it simple.

    1. Past performance is no guarantee of future results.
    2. If anything other than stocks is a bad idea for more than 20 years, why are so many banks eager to make 30 year mortgages? Why don’t they just obliviously invest that money into index funds for the expected twice as much and go play golf for 20 years?

  3. Hi Ryan. Thank you for taking the time to comment.

    My replies:
    1. Agreed completely. That said, I think there are some sound fundamental reasons to expect that stocks will outperform bonds over very extended periods. Not always, of course, but usually. Would you disagree?

    2. I’d argue that individual investors are in a much different situation than banks.

    For example, most investors typically aren’t leveraged on their investments (unless you want to count their home). Most banks are.

    The amount of volatility you can tolerate changes substantially when the majority of the money you’re investing is borrowed, right?

  4. Mike,

    1. Agree that stocks will probably outperform bonds over extended periods.

    2. (you have a couple points here)
    a. Yes, i agree
    b. I would count someone who carries a mortgage and invests in the stock market, even through 401k, as a leveraged or margin investor. Almost always an unwitting and unconscious margin investor, but leveraged nonetheless.
    c. I don’t know about that. I’m an engineer, not a banker. This is just my side interest. But back to the question, hmmm. When you say “can tolerate” do you mean “have the stomach to withstand” or “are allowed to do” or what? A private equity firm surely takes on a lot of volatility with 90% borrowed money.

    Here’s a hypothetical question to get back to the original question. Why don’t you start some sort of mutual fund, and the mechanics of this would be very simple, so hear me out. It would actually be kind of like a CD (although not insured) Let’s say you promise your investors a 7% annual return, all paid exactly 20 years from now, no distributions, harsh penalties for early withdrawals. You take all their money and invest it in, let’s say, the Vanguard Total Stock Market Index. You believe it’s going to return 10% over the next 20 years. After 20 years, you sell it, return their 7, you keep the 3, and everyone’s happy.

    It sounds kind of crazy and very elementary, but that’s basically the amount of trust you seem to be willing to put in the stock market.

    Maybe that’s reasonable, I’m not sure. Maybe my business has already been done–for example, did I kind of just reinvent an annuity?

    Thoughts?

  5. “I would count someone who carries a mortgage and invests in the stock market, even through 401k, as a leveraged or margin investor. Almost always an unwitting and unconscious margin investor, but leveraged nonetheless.”

    Hmm, that’s an excellent point.

    And as to your proposed investment, yes, it sounds rather like you did just reinvented the fixed annuity. Though 7% seems like an unlikely promise. 🙂

    Also, a quick distinction: While I’m probably more confident than most in the likelihood that stocks will outperform fixed income investments over very extended periods, I’m extremely reluctant to count on any particular level of return.

  6. I see it a couple ways…

    I like to break everything down to very, very basic terms. This is kind of the explanation I have for myself, and when my kids are older, them too, so here goes.

    We live in a capitalist economy (sort of). Therefore the way to build wealth is by owning capital. But you have to do something with that capital, not just keep it in the closet. There is an almost infinite number of investments for that capital, but I don’t think it’s unreasonable to break it down to just four types. I know, that sounds crazy right. Well here are the four, in increasing order of risk. [In brackets I’ll put an example expected rate of return]. (In parantheses I put the examples).

    1. Lend your capital to other people through a bank in government insured accounts.[3%] (Savings, CD’s)
    2. Lend your capital to municipalities [5%] (municipal bonds).
    3. Lend your capital to businesses [7%] (corporate bonds).
    4. Buy your own revenue producing and/or appreciating assets [10%] (stocks or real estate)

    Essentially, in my opinion, that’s it. Period.

    But now there are two things that complicate my list of four. The first is fairly simple to understand, and the second is a little more complex.

    1. There are sub-categories within these four of course (bond funds, index funds, REIT’s) but that’s pretty straightforward.

    2. Now the more complex part. There are alot of people that want to invest in one of the four categories above, but they want a different risk/reward profile than those basics; in fact they want a different risk/reward profile even from within that specific category. And there’s a HUGE industry that’s willing to support that, and create all kinds of products and strategies to do so. They move up the risk scale by leveraging (no secret there, and it kind of makes sense to me if that’s what you want). What DOESN’T make sense to me is picking something in category 4 (owning assets) but then trying to REDUCE the risk associated with it AT THE EXPENSE of expected reward. Diversification is one thing, I’m not criticizing that at all. What I am criticizing is the type of investing where you are GUARANTEEING YOURSELF a lower return by minimizing the risk. BadMoneyAdvice commented on one form the other day: option-call investing, basically buying a stock and simultaneously writing call options on it. I guess another form of this would be investing in something and then taking small short positions on it.
    Why do that? Why not just move down the list if you want less risk?

    That’s my pondering rant.

  7. This was a pretty interesting discussion.

    @ryan: The options route seemed to be along the lines of arbitrage to me; the value of the stock and options were poorly priced and took advantage of the differential.
    A crude example we did for a programming course was to find the series of currency trades that would let us make a profit given some rates.
    I do like how you essentially broke up investing options, tho it’s just own or lend.

    People are irrational. That is all. But in truth the small piece of mind is nice =)

  8. SJ,

    Oh, ok. Now I understand the options thing better.

    Yeah, you’re right on the second point; the first three categories ought to be sub-categories of one.

  9. You know, something else I’m thinking of (since I’m an engineer), this is all kind of like engineering design, in a way.

    Typically in designing anything, let’s say a car or a boat you can use X amount of resources to get a Y level paramenter. But to improve on that, you’ll typically have to use 2*X resources to get just 1.1*Y result. (example: it’s not unreasonable to think that to make the same cargo ship go 10% faster, it will cost twice as much).

    That seems like what happens with actively managed investing. It’s alot of extra work to eke out maybe another percent. But naturally it gets alot more complicated in finance than engineering, because you’re adding or subtracting risk and volatility as well.

    crazy.

  10. ryan,
    Off topic, which type of engineering are you involved in? What you described reminds me of optimization problems hahaha..

    Diminishing returns =)

    I think a fun question to ask people is if they would like to invest in a portfolio that guarantee’s half the return of the S&P, while also guaranteeing half the volatility… And at the same time charge a lot for the secret lol. Thus the point of asset management.
    People would buy in I’m sure =)

    As for banks, what are the rules that govern banks lol. I’m not sure what a bank is now. Do they invest sheerly in mortgages/loans right? Or do they also play the market… You got me thinking there ahhaha

  11. another “benefit” to less volatility is the decreased likelihood to panic and sell very volatile assets on their downswing which will eat into those longterm returns. if i am always making 6% every year, i am rarely (if ever) tempted to take my money out. whereas on those downswing years with the volatile portfolio, i may decide to take some out (thinking i will avoid further losses not realizing i am trying to time the market) as a defensive measure which will most likely bite me in the end when i get back in on the upswing too late.

  12. Rick Francis says:

    Ryan wrote:
    But your real question is “Why own anything other than stocks if you’re 20 years or more from requiring the money?”

    The best answer would be that holding 100% stocks doesn’t give you the best % return. I’ve heard that 90%stocks 10% cash with periodic rebalancing beats holding 100% stocks, but I don’t have a reference handy.

    I think the reason is that rebalancing between stocks and cash during a volatile period generates gains even if there is no net gain in the price of the stocks over the period. The gains aren’t huge but it would give a non-100% stock portfolio and edge that a 100% stock portfolio lacks.

    -Rick Francis

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