Which Hat Are You Wearing?

Jim Parker, Outside the Flags
Vice President, Dimensional Fund Advisors

Most of us have multiple roles—as business owners, professionals, workers, consumers, citizens, students, parents and investors. So our views of the world can differ according to whatever hat we’re wearing at any one time.

This complexity of people and their range of motivations, depending on their circumstances, highlight the inadequacy of cookie-cutter or automated investment solutions.

For instance, if you work for a taxi booking firm, you’re naturally going to take greater-than-usual interest in technology that allows consumers to book cabs directly. That’s because these new disintermediated services might affect how you make your living.

On the other hand, as a consumer you may welcome any initiative that increases competition, widens your choice and lowers prices.

As a taxpayer, you may look kindly on efforts to encourage user-pays systems in universities. But as a parent, you may be concerned about your teenage children taking on excessive debt to fund their education.

As citizens, we might champion a laissez faire approach to economic policy. But as investors, we may feel uncomfortable about certain policies and seek to express our values by placing limits on how our money is invested.

The point is everyone has the right to their own opinions and intelligent people can legitimately and respectfully disagree on many issues, including about what might happen in the world economy and about how policymakers should act.

The trick is in being clear with ourselves about which hat we are wearing when we make investment decisions and the trade-offs involved in reconciling our personal opinions with our desired investment outcomes.

For example, you may have an opinion on what central banks should do in normalizing interest rates. But do you really want to hang your decision about your portfolio allocation to longer-term bonds on your view of the interest rate outlook?

As a worker in an industry undergoing digital disruption, you may have an aversion to the technology putting you out of a job. But as an investor, do you want to forsake earning a share of the wealth from the new forces created by this disruption?

As a resident of a suburb near the airport, you may oppose on noise grounds a government decision to build a new runway, but as an investor and a worker you might benefit from the increased productivity generated by the investment.

The point is we have many roles in life and there often can be conflicts between our personal beliefs and opinions in one area with our desires in another.

Our strong view on the economic outlook may lead us to think the market will come around to pricing assets based on that opinion. But the power of markets is such that they reflect the views of millions of people, many of whom may hold contrary views.

Keep in mind, also, that competitors in those markets include professional investors with multiple sources of information and state-of-the-art technology. And even they have trouble getting these forecasts right with any consistency.

This isn’t to say we can’t invest based on our personal principles. But we first have to start from the assumption that in liquid markets competition drives prices to fair value. Prices reveal information about expected returns. That leaves us to diversify around known risks according to our own preferences and goals.

In short, life is full of trade-offs. It is the same in investment. We may pursue higher expected returns, but we want to do so without sacrificing diversification or cost.

The over-riding principle is to understand what we can and can’t control. We can have an opinion on government policy and we can express it through our vote, but we can’t control the investment outcome. We can have an opinion on what should happen to interest rates, but we can’t control what happens. So we diversify.

The role of a financial advisor is to help you understand these trade-offs and to separate opinion from fact, to balance your risk preferences with your desired wealth outcomes, and to accommodate your personal values within a diversified portfolio.

People with many hats require many different investment solutions. And that’s a good thing.

Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

Guest Article - Unhealthy Attachments

By Jim Parker, Outside the Flags
VP, Dimensional Fund Advisors

Have you ever made yourself suffer through a bad movie because, having paid for the ticket, you felt you had to get your money’s worth? Some people treat investment the same way.

Behavioral economists have a name for this tendency of people and organizations to stick with a losing strategy purely on the basis that they have put so much time and money into it already. It’s called the “sunk cost fallacy.”

Let’s say a couple buy a property next to a freeway, believing that planting trees and double-glazing will block out the noise. Thousands of dollars later the place is still unlivable, but they won’t sell because “that would be a waste of money”.

This is an example of a sunk cost. Despite the strong likelihood that you’ll never get your money back, regardless of outcomes, you are reluctant to cut your losses and sell because that would involve an admission of defeat.

It works like this in the equity market too. People will often speculate on a particular stock on the basis of newspaper articles about prospects for the company or industry. When those forecasts don’t come to pass, they hold on regardless.

It might be a mining stock that is hyped based on bullish projections for a new tenement. Later, when it becomes clear the prospect is not what its promoters claimed, some investors will still hold on, based on the erroneous view that they can make their money back.

The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don’t want to believe our efforts have been in vain. But there are ways of dealing with this challenge. Here are seven simple rules:

1. Accept that not every investment will be a winner. Stocks rise and fall based on news and on the markets’ collective view of their prospects. That there is risk around outcomes is why there is the prospect of a return.

2. While risk and return are related, not every risk is worth taking. Taking big bets on individual stocks or industries leaves you open to idiosyncratic influences like changing technology.

3. Diversification can help wash away these individual influences. Over time, we know there is a capital market rate of return. But it is not divided equally among stocks or uniformly across time. So spread your risk.

4. Understand how markets work. If you hear on the news about the great prospects for a particular company or sector, the chances are the market already knows that and has priced the security accordingly.

5. Look to the future, not to the past. The financial news is interesting, but it is about what has already happened and there is nothing much you can do about that. Investment is about what happens next.

6. Don’t fall in love with your investments. People often go wrong by sinking emotional capital into a losing stock that they just can’t let go. It’s easier to maintain discipline if you maintain a little distance from your portfolio.

7. Rebalance regularly. This is another way of staying disciplined. If the equity part of your portfolio has risen in value, you might sell down the winners and put the money into bonds to maintain your desired allocation.

These are simple rules. But they are all practical ways of taking your ego out of the investment process and avoiding the sunk cost fallacy.

There is no single perfect portfolio, by the way. There are in fact an infinite number of possibilities, but based on the needs and risk profile of each individual, not on “hot tips” or the views of high-profile financial commentators.

This approach may not be as interesting. But by keeping an emotional distance between yourself and your portfolio, you can avoid some unhealthy attachments.

Diversification does not eliminate the risk of market loss. There is no guarantee investing strategies will be successful.
Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.