How Do You 'Optimize' a Portfolio for the Real World?
Psychologist and author Daniel Crosby argues that portfolios that factor in how people behave are better than ones perfected on a spreadsheet.
Beginning investing classes teach about the importance of balancing risk and return. But they rarely entertain equally important questions, such as “Can you live with it?” and “Does it give you peace of mind?”
Daniel Crosby, a recent guest on The Long View podcast, thinks these types of behavioral considerations should be part of the discussion, too. He discussed what he calls “behavioral optimal” portfolios and how capital deployments like mortgage paydown can be optimal even if they don’t deliver a high return. Crosby also delved into the behavioral aspects of buying real estate, noting that even though home ownership provides forced saving, average long-term returns haven’t been spectacular.
Here are a few excerpts from Crosby’s recent interview.
Jeffrey Ptak: You've talked about spreadsheet-optimized portfolios versus behavior or real-world optimized portfolios. Can you explain the difference?
Crosby: There's a big difference between what we'll call the mathematical optimal and the behavioral optimal. One of my favorite stories about this, I cite it in The Laws of Wealth, it looked at the best-performing equity fund of the 2000s. So from 2000 to 2010, the S&P is slightly down over that time, but this fund, this focused equity fund, got 18.5% per year, which is just an enormous, incredible run anytime, especially over the lost decade that time was. But if you drill down, and you look at the average investor performance in that fund over that time, the average investor in that fund lost money, because of when they time their buy and sell decisions.
So, you've got the hottest fund in the world, and the average investor in that fund is losing money. And that's the most obvious and visceral example I can give of this--that there's a difference between a vehicle or a product that's going to do well and your ability to take the ride. In a personal example, my wife and I paid off our house a couple of years ago, in a move that I think no one would have told you was smart. No financial professional would say, “Mortgage rates were 2%, 2.5%--it's not anybody's spreadsheet-optimal idea of a good decision to pay off a house when you could be investing that money elsewhere.”
And, indeed, it hasn't been a good decision from a strictly mathematical standpoint, but it's really good for our peace of mind. It was really good, in March of 2020, to have a paid-off house, and that peace of mind allowed me to stay the course and stick through with the rest of my investments and take risk with the remainder of my wealth. And so that's what I'm talking about there. A lot of times I think, as an industry, we try and solve for the spreadsheet optimal or the mathematical optimal. I think when we start to have deeper conversations with our clients, though, we might see that there's a behavioral optimal that may look a little different.
Christine Benz: Speaking of behavioral finance, it seems like the whole area of home-buying, mortgage paydown, all of that stuff, is a hotbed of irrational behavior. And I'm wondering if you agree with that, and what you think consumers should be thinking about with respect to some of these decisions? How can they find touch points to calm themselves down and to make good decisions in this space?
Crosby: It's fascinating. About 10 years ago, I had a client who thought it would be fun for me in February to go stand out in the middle of Times Square for a piece we were doing, go interview passersby about the best and the worst investment decision they had ever made. And it was a miserable experience, because I'm from the deep south, and it was freezing, and I was dying. But, it was also a very instructive experience. Because, to a person, every single person said the best financial decision they had ever made was the purchase of a home. Now granted, this is overindexing on Manhattanites, who had probably done better than average on their homes. But, to a person, every single person said the worst investment they'd ever made was some stock or another. So, it's incredible to consider that if you look at history, stocks do, over long periods of time, 9% or 10% a year, on average. And homes, Robert Shiller looked at home prices for the last 100 years and found that home and investing in residential real estate basically keeps up with inflation--it's like 2% to 3% a year. So how is it that an investment that is, in reality, so bad, is the one that everyone says as their top? It's because all these biases are wrapped up in our home. It's where we bring home our babies, it's where we raise our kids, it's where we carry our spouse across the threshold to start a life together. It's the backdrop for every one of our emotional experiences and our lived experience broadly.
I think the first thing that people need to do is to get realistic expectations about what it is and what it isn't. I think a home is a great way to force savings and a great way to create a forced nest egg. But what it is not, when you look at the alternatives, is it's not a great investment on average. Maybe your mileage may vary. But, on average, it's not a great investment. I think we need to get honest about what it is and what it isn't. It's a great way to save money. It's something that you need, but it is not, when compared with the alternatives, a fantastic investment.
And then I think we need to get outside of ourselves a little bit and get this outside perspective on what homes can and can't do. What do we want from our home? And that's going to look different from person to person, but I think we need to divorce ourselves of some of these more romantic notions of what home is and get a little bit more honest about what it can and can't do. The final thing that I'll say there is when we look at the psychology of spending, buying a home is one of the worst ways to buy happiness of anything.
When we look at the positive ways to buy happiness, it's things like spending times with loved ones, giving to charity, getting out of work that we don't like doing--whether it's cleaning the house or mowing the yard--those all contribute meaningfully to happiness. But purchasing a home is very low on the list. Because we so immediately become acclimated to our home. When you walk into a new home, it's splendid, it's wonderful, it's novel, it's new, it brings you a lot of happiness. But very quickly, that home just becomes the place where you put your dirty dishes and you throw your dirty socks, at the end of the day. It very quickly becomes the backdrop of your lived experience, and it doesn't provide much happiness. So, I think if we understand all these things about the home-buying process, we're on the road to being more rational.