Investment Strategies

Behavioral economics and your portfolio

Investors don't always make decisions based on real payoffs; it is far more nuanced

Sep 26, 2010 @ 12:01 am

By Alan C. Snyder

Harvard Business School used to put 800 first-year MBA students through a tank warfare game. The goal was to prove that homo economicus — the concept championed by John Maynard Keynes and other traditional economists which postulates that humans make decisions in life based on the economic payoff they get — doesn't always apply. Behavioral economists instead argue that decision making is far more nuanced. Herd behavior, endowment theory (we disproportionately like what we own) and momentum strategies are just a few of these behavioral anomalies.

The tank game was fascinating.

Each side started with the same number of active tanks. Students would select a negotiator to meet privately with the opposing team's negotiator to discuss possible disarmament or, if talks failed, to announce war.

If the negotiators agreed on total disarmament, everybody won the most, but lying was allowed as to how many active tanks were kept.

War could be declared at any time, with the winner being the side with the most active tanks. The winner in that scenario would win a prize, but less than with total disarmament.

During each round of negotiation, a tank could be deactivated, presumably on both sides, until total disarmament were achieved.

However, one side could lie and not deactivate a tank, and then attack on the next round with superior numbers. If it was a draw, both sides lost.

Over the years, only a few teams disarmed, even though that resulted in the highest payoff.

In my year, our team disarmed, teaching a valuable lesson about behavioral economics. We disarmed and achieved the best resolution by both teams' agreeing to raise the stakes, with the negotiators holding a kitty put up by each of the teams in cold cash to ensure compliance, truth and disarmament.

The quick-to-attack tank team evokes images of investors drawn to a shiny new investment play. In theory, 2008's results taught us the truth, yet do we truly appreciate the math involved?

If an investor equaled the S&P 500 performance in 2008 of -38%, then a 61% gain would be required to break even. But that isn't counting inflation.

Between January 2008 and October 2009, the inflation rate was 2.4%, calculated from the Consumer Price Index. Therefore, an investor really needed a return of 65% last year to get back to even — a challenge few achieved.

This year has brought sickening swoons, downs as well as violent ups, with almost no rhyme or reason.

More so than in calmer times, every investment must meet these testing questions: Is this the best place for my money, given my return objectives and tolerance for risk, right now and going forward?

If the returns are highly variable, is it possible for me to achieve the “average” returns? If I choose the latest shiny object and it underperforms long-term, is that outcome acceptable, given the thrill of the chase?

Diversifying by money manager can help to lessen these risks, especially when you select experts who:

Take on additional risk. If all investors follow the same path, their returns will be average at best. Carefully selecting strategies and managers that have higher-than-average risk and return as part of an overall portfolio is a requirement for above-average performance. The key ingredient is creating a portfolio in which the overall risk is reduced and the return is enhanced.

Stay outside institutional bureaucracy. Many institutional money managers promote their investment committees as never straying from the strategy set out by the key executive officers. Does this sound like an approach that will lead to superior results? The results are usually average but comfortable, much like a bowl of oatmeal. Winners are specialists — non-traditional, unconventional, non-consensus, contrarian, occasionally pioneering, skin-in-the-game managers who use strategies that are carefully blended.

Hedge through diversification. A concentrated wager can win the most when properly placed. It also clearly can lose the most. Diversification, reasonably undertaken, mitigates risk and can serve as a worthwhile hedge.

Perform over the long term. Any single strategy or manager can shoot out the lights over a short period of time. Equally so, there can be periods of relative underperformance even from a best-in-class practitioner whose strategy or asset class is out of favor. A reasonably diversified blend smooths out these results. Unfortunately, it is impossible to hop from one superperforming lily pad to another without the risk of missing the pad, falling in and drowning.

Alan C. Snyder is the managing general partner of Shinnecock Partners LP, a hedge fund company.

For archived columns, go to InvestmentNews.com/investmentstrategies.

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