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How Rational is that Decision?

 

 

Today marks the one year anniversary of my blog.  In celebration, I am announcing that it is now easier than ever to find and use it.  In addition to the usual way, you can also access it by visiting either: www.standuptobullshift.ca  or www.standuptobullshift.com

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Yogi Berra once quipped that the difference between theory and practice is that in theory there is no difference, but in practice, there is.  Here’s the thing about that observation as it pertains to finance and decision theory.  If you substitute the words “traditional finance” and “behavioural finance” for “theory” and “practice”, you get the same observation.  Basically, traditional economics assumes that decision-makers are rational, self- aware, self-interested actors, but behavioural economics shows they are not.  Despite this, the industry acts as though decision-makers are rational.  We can debate whether the guilty decision-makers are advisors, clients, or both, but the concern should be obvious either way.

 

In classical decision theory, people have consistent preferences which include a presumed continuum of options that make rational risk- return tradeoffs.  Unfortunately, Prospect Theory shows that that is seldom the case.  I’m especially worried about how that might play out in 2021. My concern is that modern portfolio theory (optimizing risk / return tradeoffs along a so-called ‘efficient frontier’) makes sense of peoples’ risk preferences in theory, but not in practice.  Recency Bias, Resulting and widespread Optimism Bias are likely causing investors and the advisors who offer counsel to them to go further rightward on that frontier than would otherwise be considered prudent.  People are reaching.  Follow the steps:

 

  1. There’s broad consensus that, owing to low inflation and low growth, expected returns for both stocks and bonds will be lower going forward
  2. In addition, there’s a growing consensus (but still not a ‘concern’, IMO) that valuations are stretched for both stocks and bonds, lowering expected returns even further
  3. Many people (investors and advisors alike) haven’t adjusted appropriately. Instead of updating their plans with lower expected returns, they have reached for yield and added – perhaps unwittingly – to their risk budget.

 

Many advisors define their value proposition in terms of return maximization.  Relatively few seem concerned about risk minimization.   As long as markets move up, as they have for the past ten months or so, there’s no perceived risk in reaching.  In fact, until now, the people doing the reaching have been rewarded.  Until now.

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