Portfolio Theory – In investment, the whole should be greater than the constituent parts
Our recent assertion in All together now that investments should not be considered in isolation but as part of a portfolio has an echo in the work of behavioural economist Richard Thaler, whom we last met in Less is more. His latest book, Misbehaving: The Making of Behavioural Economics, includes an anecdote about a seminar on decision-making he once gave to a group of executives.
Thaler asked them all to imagine a scenario where each of their divisions was offered an investment opportunity that had a straight 50/50 chance of yielding a good or a bad outcome. After the investment was made, it would either lead to a profit of $2m (£1.31m) or lose its division $1m. Thaler then asked for a show of hands to gauge who would be prepared to take on such a project.
“Notice that the expected pay-off of this investment is $500,000,” Thaler points out, “since half the time they gain $2m – an expected gain of $1m – and half the time they lose a million – an expected loss of $500,000.” He adds that the company was large enough that a million-dollar loss, or even several of them, would not threaten its solvency.
Even so, just three of the 23 executives present said they would take on such a project. Thaler then asked the company’s chief executive, who was observing the seminar from the back of the room, how many projects he would want to take on, on the basis they were independent from each other – in other words, the success of one was unrelated to the success of another.
The chief executive replied he would do the lot. Buoyed by a little mental arithmetic – and perhaps an MBA – he knew that his firm could be looking at a profit of $11.5m on the 23 projects yet the chance of losing money overall from the portfolio of projects was less than 5%. “He considered undertaking a collection of projects like this a no-brainer,” writes Thaler.
Unfortunately for the chief executive’s ambitions, his staff were clearly less concerned by any potential profit than the possibility of losing their division $500,000. In the words of one of the executives, he liked his job and was not prepared to risk it on what was effectively a coin-toss, when all he stood to gain was a bonus of perhaps three months’ salary.
Thaler saw this attitude as a problem – though more for the chief executive than his heads of division. Although they knew in theory the course of action they should take, their employer had not created an environment where it was felt that risk-taking – even, as in this scenario, where the odds were broadly in their favour – was tolerated let alone encouraged.
This behaviour is something that Thaler calls ‘narrow framing’ – that is, seeing events in isolation rather than taking them together. “When broadly considering the 23 projects as a portfolio, it is clear that the firm would find the collection of investments highly attractive,” he writes, “but when narrowly considering them one at a time, managers will be reluctant to bear the risk.”
Here on The Value Perspective, we come across this sort of thinking in a slightly different context. Often when we are talking to other people about our portfolios, we will find they fixate on a particular stock that may have done very well or very badly. That is, to some degree, understandable – unusual is almost by definition interesting – but it risks missing the point of collective investment.
In a portfolio, the individual returns are all but irrelevant and what matters is the blended returns that accrue, on average and over time. Whether that means half your stocks do very well while the other half go bust or something rather less dramatic, it does not really matter providing you are investing – as in Thaler’s example and as value investors strive to do – with the odds in your favour. As we have written many times before, in articles such as Horse sense, this is exactly what disciplined value investing can achieve.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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