After so many quarters of diversified portfolios underperforming a simple S&P 500 Index fund, we are digging deep to come up with new ways to frame the argument that yes, it's boring, and yes, it hasn't worked, but diversification is still important. Our angle this time is through Richard Thaler. Here is an excerpt from our third quarter 2017 commentary:
Richard Thaler, as was announced in early October, won this year’s Nobel Prize in Economics. This NYTimes article provides a great review of his pioneering work in the field of behavioral economics. If you ever took an economics course in college, you might remember that economists love to simplify away all the complexities of the world in order to fit behavior into a neat model. One of the most popular simplifications is to assume that humans behave in a consistently rational fashion – homo economicus. Of course, we all know that man does not always behave in a truly rational manner (Ayn Rand characters, perhaps, excepted). Thaler’s work goes one step further to show that people depart from rationality in consistent ways – ways that economists can model.
One example of Thaler’s impact in the investment world is workplace 401(k)s. Not acting is easier than acting, and the preferred outcome is to have employees invest for their retirement. Thaler popularized employers’ auto-enrollment of participants in 401(k) plans, allowing them to act to opt out. This shifts the behavioral tendency toward inaction from the less favorable outcome (low rates of enrollment) to the favorable outcome (more employees saving for retirement). In addition, he developed the idea of "auto-escalation," or automatically increasing the percentage of an investor's pre-tax salary that is diverted into a workplace retirement plan on an annual basis. The combination of auto-enrollment and auto-escalation is powerful. Want to learn more? This Bloomberg article provides a great overview of how Thaler's work is being applied in workplace retirement plans to improve investor outcomes.
When asked how Thaler would spend his ~$1.1M Nobel prize money, he answered, “I will try to spend it as irrationally as possible.” Let’s say instead that his desire is to invest it as irrationally as possible – why not put 100% of his money into this month’s top performing asset class, hold it for one month, and then sell it and buy the new top performer? Homo economicus, of course, would invest in a long-term, diversified investment portfolio designed to meet his financial goals. There are months when Thaler’s irrational investment style might beat homo economicus, but over the long run, we believe that diversification and avoiding timing mistakes gives the edge to homo economicus.