A piece titled The Psychology of Money written by Morgan Housel made its rounds on the internet in June. It was an excellent collection of 20 flaws, biases, and bad behaviors that the author has observed when people deal with money. I did not fully agree with flaw number 10 – “An appeal to academia in a field that is governed not by clean rules but loose and unpredictable trends.” My approach to investing and financial advice relies heavily on academic research.
Housel cites a Wall Street Journal interview with Harry Markowitz, the man who pioneered modern portfolio theory – the idea that an optimal portfolio exists. When asked in the interview how he invests his own money, Markowitz did not answer that he uses mean variance optimization to build an optimal portfolio. Instead he explained:
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. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.
Housel seems to offer this as an example of how far off academia is from being helpful to human investors. I see this story as Markowitz recognizing that his model, like any model, has limitations. Models are simplifications of a complex world. They are inherently false. This fact should not be used as an indictment of models.
Merton Miller has explained that there are no good models. A model’s is usefulness depends on the user of the model, and its application. This is where human judgement and an understanding of human psychology comes into play.
Housel accurately writes that “real-world people use [academic research] as a crutch to try to make sense of a messy and confusing world that, by its nature, eschews precision.” While this is true, it is not a reason to discount the role that academic research should play in real-life investment decisions. The key is understanding the tradeoff between optimization, judgement, and behavior.
Those insights can have an impact on how a portfolio is structured. I would never suggest full deferral to models, but I do believe that their application to investment decisions is extremely important.
For example, I follow the academic research that small stocks, value stocks, and highly profitable stocks have higher expected returns. Blind application of this model would see me recommending portfolios consisting of only the most profitable small cap value stocks. In reality, I recommend investment products that own the whole market with a slightly higher weight in these types of stocks. Even if the model is wrong, the end result will still be pretty good.
Housel writes “The disconnect here is that academics typically desire very precise rules and formulas.” This is not always true. Ken French, who is intimately involved with the research that I have mentioned, has explained that, to him, academia is less about uncovering and disseminating facts, and more about changing the way that people think. We will rarely know the right answer, as Housel demonstrates with his Markowitz example, but if we can tend toward a better answer through academic research we may be able to make better decisions.
Finally, Housel points out that there is an attraction to the titles and degrees that academics hold because, unlike something like medicine, finance is not a credential-sanctioned field. He follows this up with “A hard reality is that what often matters most in finance will never win a Nobel Prize: Humility and room for error.” It is true that many academics with impressive titles are not sources of good financial advice. Where I believe that Housel falls short is that humility and room for error alone are not sufficient to make good financial decisions. The application of great research with human judgement, humility, and room for error may be the most useful approach to financial decision making.
