We live in a complex world. Trillions of variables interact in a multitude of ways every single second. This makes it very hard to decompose most aspects of reality into their constituent parts and analyse them separately; reductionism is a dangerous practice in this type of environment.
It can neglect the relationship that components have with each other. Components that may not seem that useful in isolation, but are actually very useful when you zoom out and consider the bigger picture.
What can this tell us about personal finance?
When constructing a portfolio, don’t think about each asset you purchase on a purely individual basis. Because we don’t care about the performance of individual assets, just the portfolio as a whole. I don’t really care if stock X is up 20% if my portfolio as a whole is down 5%.
Reducing the portfolio to each asset also undervalues the benefits of owning assets that may not necessarily generate high returns most of the time, but nevertheless play an important role in the portfolio overall. Imagine that correlation between assets was stable and well-behaved. Adding an uncorrelated asset, that may not even be well-performing, to your portfolio can actually increase returns overall. Although financial markets are becoming increasingly interconnected, these types of relationships are still possible to find. Imagine you owned an index that tracked the Brazilian stock market (boa sorte). An economic crisis in Brazil is going to tank your portfolio to a lesser extent if you also own some Japanese government bonds, even though these bonds might be a less-attractive investment prospect.
This is basically why hedges are valuable. They aren’t needed most of the time and are often too expensive…by themselves (although this depends on how exactly you analyse the problem). But when combined with riskier assets, they magically become net beneficial.
Only lifetime matters
And it’s not just when thinking about the components of the portfolio that investors make this mistake. You have to think about your portfolio across space and time. Don’t just think about returns over the last month or last 3 years or the next 5 years. Think about lifetime CAGR.
Reductionism here is mathematically dangerous. If my returns over the last 3 years have been 30%, 10%, and -10%, by looking at each of the three years sequentially, I might be tempted to conclude that my average return was like 10% per year. This is a common mistake – employing the arithmetic mean rather than the geometric. This is far less likely to happen if we are focused on lifetime returns – on lifetime CAGR. In this scenario, the correct return is 28.7% overall and 8.8% per year. This equates to a small difference here but if you increasingly partition and extend the investment horizon, this difference can get rather large.
Focusing on individual time periods rather than lifetime CAGR can also lead to psychological pain, because asset prices over small time periods are largely the consequence of noise rather than signal. So, even if an asset is likely to increase in value in each period, you are still likely to suffer through many losing periods.
As a simple example, imagine an asset valued at $1,000 that had a 51% chance of increasing by $1 every day and a 49% chance of decreasing by the same amount. If you monitor this asset Every. Single. Day. it will seem as if it’s not really increasing in value at all, just constantly moving up and down. Because it is – it is only slightly more likely to increase in value on any given day. But, according to my Monte Carlo simulation with 100,000 trials, this asset actually has a 63% chance of increasing in value each year. This probability becomes greater the longer you extend the time horizon.
Viewing each time period separately is also a mistake because we may feel the need to win in each of these periods. This prevents us from making sacrifices now in order to win bigger later. If you consider your investment horizon in its totality, losing in any one period won’t bother you. This allows you to invest in higher-risk environments or assets that may decrease in value in the short term but have more upside.
Zoom out again
We can extend this idea up another level: don’t just think about your portfolio by itself, think about it within the context of your personal finance structure.
Again, components must be valued with knowledge of their surrounding context. A high-performing portfolio becomes less valuable in the absence of an emergency fund, because this portfolio would need to be partially liquidated in the presence of unexpected costs without this fund. So the investment horizon becomes more stochastic, and the investor is less able to take risks.
Another example: saving becomes less effective if you 1) make the wrong investments and/or 2) are in debt. Because these savings will be 1) subject to negative returns and 2) used to make interest payments.
Let’s zoom out even further: personal finance is just one part of life. It must improve your life as a whole, otherwise it’s a waste of time. So don’t live frugally forever – that doesn’t sound very fun, even though it does sound fun for your bank account. Don’t make investments that prevent you from sleeping at night, even if they are likely to increase your portfolio returns.
All personal finance and investment decisions must be conducive to the life you’re living or the life you want to live.