Financial Advice and Investment Decisions: A Manifesto for Change

By Jarrod W. Wilcox and Frank J. Fabozzi

A practical guide to adapting financial advice and investing to a post crisis world 

There's no room for "business as usual" in today's investment management environment. Following the recent financial crisis, both retail and institutional investors are searching for new ways to oversee investment portfolios.  How do you combine growth  with a focus on wealth preservation? This book offers you a fresh perspective on the changes in tools and strategies needed to effectively achieve this goal.

Financial Advice and Investment Decisions provides today's investment professionals with the conceptual framework and practical tools they need to successfully invest in and manage an investment portfolio with wealth preservation as a key concern. While there are many qualitative discussions, the authors present strong quantitative theory and practice in the form of small conceptual models, simulation, and empirical research. 

• A comprehensive guide to properly managing investments with a focus on matching security and growth goals with the needs of the investor
• Blends insights gleaned from portfolio management practices used prior to the market mayhem of 2007-2009 with cutting-edge academic and professional investment research
• Includes innovative and wide-ranging treatment of subjects such as augmented balance sheets, the efficiency of markets, saving, spending, and investing habits, and dealing with uncertainty
• Description of opportunities for improving the investing environment

The recent financial crisis has opened our eyes to the need for improving the way we invest.  This book will put you in a better position to excel in this new economic environment.

• Language: English
• Publisher: Wiley
• Release date: Nov 20, 2013
• ISBN: 9781118415320

Book preview

CHAPTER 1

Why Do We Need Better Financial Advice?

Money and finance are wonderful inventions. But our makeup is not yet perfectly adapted even to the uses of money. We have inborn instincts for success within family and small groups, but success within money-based economies is far less natural. A competitive public marketplace for legal documents such as stocks, bonds, and derivative instruments is even more unnatural than trading for goods and services using money. Many look with disdain on the accumulation of money through financial markets. This further discourages us from its mastery, especially from competence in those skills—such as reasoning with probabilities and treating shared beliefs with skepticism—that we associate with gambling and speculation. The financial environment seems too complex for real comprehension, and we fall back on ancient behavioral mechanisms that economists, who like to think of themselves as scientists battling the forces of superstition, term irrational.

In this short introductory chapter, we meet the financial enemy, and he is us. All of us need better financial advice—and some of us should share it. To motivate our book, we need only illustrate financial decisions we see frequently in practice. We start with the individual investor, move on to organizational influences, and finally touch on our government, at least as exemplified in the United States. Opportunities for better financial decision making, better financial advice, and better financial laws and regulations will be obvious. In the following chapters, we support our view in depth and go on to make specific recommendations.

When we refer to the financial decision maker as you, we realize, of course, that you would never make all the mistakes we now describe. But put yourself into this picture, and you might be surprised to see how well some of it fits. We illustrate this with an unduly confident investor, but overly cautious investors make mistakes of their own.

THE INDIVIDUAL

You are 23 and are just beginning your first serious full-time job. Do you save part of your paycheck? You may live for another 60 or 70 years, or more, and will want to have an acceptable income throughout. Yet, the image of those far-off spending needs pales in comparison with today’s desires. So, do you stop to calculate the very positive effect of an early financial savings stream on your well-being decades from now? Not likely. You are ripe for bad financial advice, not from professional advisers, or even from the financial media, but from consumer advertising: It is good to spend on better cars, on better clothes. In the succeeding years, this message will be directed toward a more upscale vacation and a bigger house. You may think spending is even patriotic because it helps the economy. You save very little, losing the opportunity to benefit from the compounding of returns on savings and investment over long periods.

Now move forward in time. You are 30, have married, and you and your spouse have a first child. You want to buy a house large enough for a growing family and in a good school district. Fortunately, the government has a program that requires a very low down payment, which is a great deal because house prices have increased fairly steadily for many years. Despite your lack of collateral and savings, your bank is happy to give you a mortgage.

Later, you are 40 years old, have advanced your career, and met some of your family responsibilities. You want to begin to build retirement savings. You are planning for retirement in another 25 years. How much of your savings, that is, your investment portfolio, should you put into stocks as opposed to bonds and other financial assets? How much of your portfolio should you allocate to asset types with different risk characteristics? Nobody knows the future with certainty, but you see that stocks have done well in the last 10 years. You want to put most of your funds into things that have demonstrated good returns.

On the other hand, how much risk can you tolerate? Based on filling out a broker questionnaire, you decide that you can handle stock market ups and downs so long as they are not too bad.

Moving forward again, and looking back from age 50, you remember going through a horrendous time when the stock market crashed. You sold all your stocks at just the wrong time because, subsequently, the stock market recovered, leaving you safe but with not much to show for the last decade of investing.

You decide now that you need better financial advice. But to whom should you listen? Your best friend recommends an adviser. The adviser asks how much you want to spend in retirement, and you provide that information. Then the adviser evaluates your savings plan and current investments, and tells you that you will not have enough to absolutely assure that much future spending. However, if you invest wisely, and take a little risk, your returns should be about 8% a year, which is what big pension plans assume, and that will meet your retirement spending plan.

You and your adviser also agree on an investment plan. You are going to do your part. You have been successful in business so far, and although your investing has had its share of disappointments, you believe you have learned from them. You can certainly do better than an index fund, and you have a special feel for stocks in your industry.¹ But to be conservative, you have your adviser pick some mutual funds with great records in which to invest part of your savings. You urge your adviser to pick the best manager of the available choices in each category.

At age 55, you realize that maybe you were not so great at stock picking. The problem seems to be that the strategies you had read about did not always work. Your adviser wasn’t so great, either. The high fees on the mutual funds selected by your adviser would not have been bad if the funds had continued their prior good performance, but you discover the funds did not do even as well as an index fund. Concerned that you had put your faith in the wrong person, you find a better adviser who had done much better over the last five years.

In the years until you reach age 60, the economy does fine and the stock market moves to new highs. The new adviser does well, too, with selections that go up even more than the market. Your bonds are a bit of a drag, so you begin allocating more to stocks.

At 65, you retire. You ask your adviser, How much can I afford to spend a year when I retire? The financial adviser responds, Each year, take 4% of what you start with at retirement. That has almost always worked. That doesn’t sound too bad, though you were hoping for at least 5%. You are in great health, so you and your spouse are planning to do a lot of outdoor activities and travel.

At age 70, your conventional investment funds are no longer quite able to supply you with your planned income on a sustainable basis. There was a financial crisis, followed by years of near economic depression. You had followed the 4% spending rule, but it was a little too aggressive with the lower returns, higher taxes, and the inflation that followed the years of economic trouble as the government found itself under too heavy a debt burden. So you take the advice of your adviser, who suggests a fund that owns stocks and writes call options to convert option time premiums into additional income.

At age 80, your investment portfolio’s value is reduced to the point where it is clear it will not support your current moderate spending pattern. Your option income fund went down a lot. Disgusted with stock market crashes and current low interest rates on bonds, you consider buying an annuity, but the income from it would not come close to meeting your needs. Your good health is a bit of a mixed blessing, because either you or your spouse can expect to live for another 15 years.

In the preceding example, every choice you made could have been greatly improved. Yet every choice was one that many people make. And many others don’t do even as well as in the example because they save very little in the first place. In the following chapters, we explain how to do better. But let’s go on, because it is not just individuals who need to improve, but organizations and government as well.

ORGANIZATIONAL INFLUENCES

Let’s leave government aside for the moment. Looking at our schools, our employers, and different types of financial service businesses, we can see some problematic influences on the individual investor that might have occurred in the preceding example.

From a young age, you are subject to the influence of consumer advertising, implicitly opposed to taking advantage of the enormous power of compound interest over long periods. We cannot blame advertisers for wanting you to buy their products. But this advertising does not come with a label: Warning: this product may be injurious to your financial health. Each of us must strike a balance between current and future satisfactions, and unfortunately, although high school included material on health, there is too little in the way of financial health.

You were later employed by a firm offering a defined benefit pension plan. After investment returns were generally positive for some years, pension fund actuaries extrapolated them far into the future. The employers responsible for assuring the benefits of such plans were generally happy to agree, because long-term optimism reduced their short-term obligations to contribute to the pension fund. And so, too little was saved to pay future pension benefits. If the firm gets in trouble, even if your benefits were vested, negotiations may be reopened.

The willingness of bankers, and particularly less regulated mortgage bankers, to help new homeowners assume very high financial leverage was revealed as a tragedy in the 2008 financial crisis. But why would sensible bankers do such a thing? The premise was that mortgages were not in high risk of default, even with very slight down payments, because housing prices had been going up fairly steadily for many years. Besides, the lenders were selling off much of the credit risk. We can’t blame them for wanting to make a profit, but many of the same organizations lost heavily in the crisis from their remaining exposure, so it is not clear that the game was worthwhile except in the very short run.

Financial planning based on asking investors how much they want to spend on retirement, and goal setting in general, is fine if the decision variable to be adjusted is how much to save. But to the extent it only influences investment allocations to take on more risky investments so as to stretch returns to meet the goal, it is not helpful because it does not increase the ability to take risks. However, it does generally increase fees. We don’t suggest that financial advisers are bad people. Many are very sincere in their desire to help. But as Karl Marx noted over 150 years ago, ideology often unconsciously reflects material interests.

Rules, such as spending 4% of initial retirement income, may work reasonably well on average; however, there is nothing magic about that number, and in some cases it should be lower. Such rules do not incorporate enough flexibility in consumption spending. In effect, they transfer current consumption risk to future risks that could precipitate a downward wealth spiral. We have to recognize, however, that it may be very uncomfortable for an adviser to tell a client that he or she must cut personal consumption, especially after one has been working with the client for years and will be blamed.

Pension funds deciding on investment managers to retain to manage a portion of its funds and financial advisers recommending mutual funds both tend to recommend those funds whose managers have done particularly well over the previous five years. Yet the evidence these managers and funds do better than average over the succeeding five years is scanty and sometimes perverse. Why do these professionals make this same mistake individual investors make? Of course, we know that agents have agendas different from those of the people who hire them. But many, probably most, of these professional agents sincerely believe they are adding value.

Broker questionnaires satisfy legal obligations to know your customer and make sure that investments are in some sense suitable. But do they really forecast how investors will behave if they lose a substantial amount of money? Even putting emotions aside, they measure a subjective belief today rather than the more relevant objective financial need tomorrow.

There are rules on how investment return performance must be reported, but they do not require after-tax, risk-adjusted measurements. If this were done, and compared with the same measurements on a benchmark passive index fund, it would be much more difficult to tell even naive investors a plausible story of unusually good return prospects. With very few exceptions, fund managers make no attempt to educate their investors on how to assess their performance. In general, portfolio managers strive for the best returns they can achieve on the measurements they have been given. But, again, ideology unconsciously reflects material interests. What does a well-established and profitable business organization do if they have no business model for profitably serving the educated investor?

By the way, we are not suggesting that professional investors have no skill in improving returns beyond those of passively managed index funds. We are saying that on average it is difficult for their clients to capture that benefit after fees and expenses.

Investors seeking higher retirement income are often tempted by brokers and other financial advisers pointing out opportunities to invest in complicated products such as option-income funds, master limited partnerships, and other investment approaches that averaged over enough time essentially provide extra distributions while reducing their capital. Even professionals who manage such funds may not be fully aware that this is what they are doing.

Successful boutique investment management organizations often earn their reputations with a well-defined investment approach. They attract investors who then feel they have bought that approach, not just the firm executing it. When the investing environment changes, if the manager adapts by altering the approach, investment consultants and their own clientele will often complain bitterly of lack of focus and discipline. So most managers stick to their advertised approach, even when they suspect it is not the best they could do. This is so ingrained that it constrains their research into new methods as well. A good example occurs when so-called quantitative managers are flummoxed by discontinuities in statistical relationships governing return correlations and predictors. They could address this by blending qualitative and quantitative methods, but refrain from doing so out of concern for losing existing customers and consultant referrals.

We could go on, but you get the idea. Organizational influences on the investor suffer from benign neglect in schools, shared ignorance by employers, short-term profit desires in many financial service arrangements, and from the simple need to retain customers who believe smart people should be able to make them more money than an index fund. We did not always see it this way. What has changed?

Empirical research and new technology have transformed the formerly acceptable to unacceptable. Previously, no one knew how powerful highly diversified passively managed index funds could be. Some professional investors had found very profitable investment approaches because there was less information available and the markets were consequently less competitive. Now the market is more efficient (except when everyone is thinking alike). Also, as in other fields of endeavor, what was once good quality has become perceptible as poor quality. At the same time, advances in knowledge and technology have also created a world of greater complexity. The general public and the organizations that serve it have only started to catch up. So have those who represent us in government, to which we now turn.

Government

In a democracy, government cannot get too far ahead of the ideas of the electorate. And we know that new ideas are often actively resisted, and that this is a natural consequence of their tendency to divide us into winners and losers. In the United States, this seems to be true for both Republicans and Democrats. As technocrats, we believe government nevertheless can and should be wiser. It is painful to watch our government trying to adapt to the modern financial world. We illustrate this with several examples.

Saving

Demographers have known for many years that birth rates are declining, that people are living longer, and that new medical technology is making it possible to extend life—but at high costs. We have known for many years that the ratio of actively working people to people past working age is shrinking and will shrink further. Yet the United States does little to increase savings and, at the same time, it further increases our collective financial obligations to the elderly.

It gets worse. Decades ago, there was a decline in the popularity of socialism and a consequent widespread adoption of mixed economies with free market components throughout much of the economically underdeveloped world. It became obvious that globalization of high labor productivity would take place, and that workers in the most developed economies in Europe and North America would now have to compete with vast numbers of workers in formerly less-developed economies. Economics 101 said that if the supply of skilled labor applicable to tradable goods and services doubled or tripled, this would have an effect on incomes of labor in the developed world.

Those in government had every reason to suspect that this enormous increase in skilled labor supply would worsen the ability of most people in developed economy countries, including the United States, to increase or maintain their living standards. Yet the U.S. government has encouraged us to spend on consumption so as to keep up employment in the short term rather than to save and invest funds in infrastructure, capital equipment, research, and education to provide for longer-term success.

It gets even worse. Though the impact of globalization will eventually become more bearable as living standards around the world come closer to those of the advanced economies, we suspect that further stresses lie ahead. Computerized automation of job content seems to be moving faster than the ability of people to educate themselves for higher skilled jobs.

Exhibit 1.1 shows the decline in the U.S. personal savings rate during recent decades. There is a brief partial recovery after the 2007–2008 financial crisis, but it seems to be settling back to very low levels. If government shows no inclination to prepare for the future, is it surprising that neither would individuals?

EXHIBIT 1.1 The Decline in the U.S. Personal Savings Rate

Source: St. Louis Federal Reserve Bank.

What has all this to do with financial advice? Everything. The decision to save is the most fundamental of financial decisions, whether it is in terms of securities, cash, or real resources. If our government won’t save, most of us won’t save enough either.

Persistent Low Quality

One of us once heard a broker compare himself to a heart surgeon. He said, the only difference is that I operate on their wallet. The analogy with the medical profession is apt. Up through the eighteenth century, medicine was associated with bleeding the patient, and a wide range of treatments of no value but big promises were common until the twentieth century. Eventually, with collection of reliable data, government required the medical profession to reform itself, even though legislators were not medical experts. Today, doctors must meet educational and professional requirements, and new drugs are required to show efficacy and safety.

Our government is a little behind this standard in the financial service industries. We disclose in fine print that past performance is no guarantee of future returns. We do not require labels that show just how little past performance is worth in indicating future performance, nor what side effects should be guarded against. We do not require those calling themselves financial advisers to accept fiduciary responsibilities. Not every financial product or service requires a fiduciary standard, but we are missing even a first, do no harm financial Hippocratic Oath.

There are many examples of government financial naiveté that prevent improvements in financial product quality. They often can be summarized as overreliance on industry in setting regulations. A current example is an argument over whether money market funds should be required to mark to market their investments. True, such funds would be less popular if it were clearer that their principal were not guaranteed. But to allow the public to think that they can’t lose money is not proper for government unless it is true.

A more subtle example is found in the U.S. government’s attempts to stimulate home purchases, with the form of help being influenced by giant lenders like Fannie Mae and by investment bankers anxious to sell securitized mortgages. Before the 2007–2008 subprime mortgage crisis, banks were motivated to become pass-through mortgage lenders, leaving much mortgage origination and mortgage holding to others. As a result, the demand for credit skills was lowered and the quality of feedback to marginal borrowers reduced. After the crisis, both non-bank mortgage origination and the demand for private repackaging of mortgage pools shrank dramatically. Subsequently, however, because of the U.S. government’s efforts to help homeowners recover, further forced declines in interest rates, as well as competition from the Federal Housing Adminstration (FHA), Fannie Mae and Freddie Mac, have essentially forced banks to lend to only the most creditworthy homebuyers. Without bank risk-based pricing for less creditworthy borrowers, the indirect result is to continue diminished demands for a full range of credit skills within the bank.

As a result, the quality of the product (home mortgage loans) has been reduced, because borrowers can less rely on bank feedback to tell them how much house, if any, they can afford to buy. This is an example of government not only being perhaps unduly influenced by industry, but of government not foreseeing the indirect effects of what naively seemed to be a straightforward subsidy of home ownership.

Booms and Busts

Does the government stabilize the economy? Or do its actions promote instability? Consider the home mortgage boom and bust that collapsed in 2007–2008. It can arguably be laid at the feet of an accommodating Federal Reserve’s low interest rates, loose banking regulation, and Congressional encouragement of excessive mortgage lending. Though the housing bubble was not hard to observe at the time, the government seemed to be surprised when it burst.

In the succeeding five years, the Federal Reserve has maintained super-low interest rates, striving mightily not only to enable banks to repair their balance sheets, but to help with the unemployment picture. Some have expressed surprise that low rates have not done more to spur lending, forgetting, perhaps, that lending is a function not only of fund availability, but also of borrowing requests and perceived creditworthiness. So the Fed persists with quantitative easing programs, one, two, three and more. When the government persistently injects more subsidies into security market prices, as the Fed has done by a long-term project of buying bonds to push interest rates down, the change in prices triggers trend-following by many investors. Such momentum investing is the source of much of the instability in market prices, amplifying as it does any trend, and easily pushing prices past their equilibrium points. At the time of this writing, we may now be in a bond bubble, in danger of seriously disappointing recent purchasers if interest rates begin to climb.

THE REST OF THE STORY

We hope these examples illustrate the breadth of the problems raised by poor financial decision making. They are so widespread that they affect all of us. Many readers will think we are exaggerating. In Chapter 2, we refer to compelling research evidence to support our thesis of widespread financial dysfunction. The opportunities for improvement are mindboggling.

What tools do we offer for addressing them? We provide the reader with empirical research findings, with critiques of received wisdom, with explanations of investing practice, with what we think are improved conceptual models and frameworks, some original, some well-known but insufficiently employed, and with a sprinkling of comments reflecting our own experiences as professional investor and teacher. Why such a potpourri? It is probably a mistake to approach financial decisions with only one model of reality. The financial system and personal financial decisions are inherently complex. No single model or method, if it is to be understandable and widely useful, will capture every relevant fact or insight.

Consequently, the next part of the book provides building blocks for developing your framework for financial thinking in what we believe is a very productive direction. Chapter 3 begins with simple models for financial planning using balance sheets extended to include planned future cash flows. Chapter 4 turns to a discussion of mostly efficient markets, which upend common sense. Chapter 5 introduces the discretionary wealth approach to financial decisions, which helps one set risk tolerances for better long-term performance using objective criteria. In Chapter 6, we introduce Bayesian probability thinking, and apply it to the problem of making investment choices. Finally, in Chapter 7, we come back to the need for self understanding, which is one way of describing what is academically known as behavioral finance.

The following part of the book makes the application of the building blocks more concrete with implementation detail. Chapter 8 discusses how to be more tax efficient in investing. Although tax rates are subject to political renegotiation, the basic principles will endure. Chapter 9 treats the opportunities for better matching investors to investment products and strategies. We believe that one of the great chances for an improved financial service industry lies in adding value through customization. Chapter 10 distinguishes active from passive investing, and discusses when each is appropriate. In Chapter 11, we present some radical but, we believe, very practical ideas for better performance measurement. To round out implementation insights, we discuss in Chapter 12 some of the main challenges met in delegating investing responsibilities to professionals.

The last chapter of the book, Chapter 13, stands on its own as a discussion of the relationship between financial advice and the society we live in. Our view is that the current situation is no longer acceptable, and we argue for change using simple feedback models as a device for focusing on key areas where improvement will help push previous reform efforts to have greater effect. Our thesis is that better financial decision making can have a profound impact on our modern financially oriented society. We believe it can promote economic efficiency, support more growth and innovation, advance the right kinds of talent, aid social cohesion, make government wiser, and generally help in the pursuit of happiness.

The only way to find out if we are serious is to read the rest of the story.

¹An index fund is a fund that provides broad market exposure to an asset class such as stocks or bonds. The fund manager does so by investing in a portfolio that is constructed to match the performance of some market index. The market index in the case of stocks can be, for example, the Standard & Poor’s 500 Index. Investing in index funds is referred to as passive investing The pros and cons of passive investing versus active investing is the subject of Chapter 10.

CHAPTER 2

The Evidence Is Compelling

We want you to be convinced of the need for improved financial advice. You need not take our word for it. This chapter supports our view with the research findings of others. We also take some potshots at famous theories that seem not to have gotten very far in helping most people save and invest.

FINANCIAL PLANNING

Aesop’s fable of the grasshopper and the ants reminds us that financial planning in some form has been around for more than two thousand years. More recent academic advice is strongly influenced by the work of Franco Modigliani in the 1950s. The life-cycle hypothesis for which, in part, he received the 1985 Nobel Prize in Economic Science, essentially states that individuals act to smooth the utility of their consumption over time. The life-cycle model does not in itself suggest specific assisting mechanisms in an imperfect world. To the extent that the model is operational, it reflects the common sense that we should save enough to support ourselves in our old age.

In contrast, substantial proportions of the United States population experience severe declines in economic well-being during retirement.¹ In a test situation with an objective determination of time preference, Ameriks et al. (2004) found that even among a group of highly educated and relatively affluent subjects there were subpopulations with exaggerated preference for current rewards over future rewards, and that these subjects possessed less monetary wealth on average.

Thaler and Shefrin (1981) gave us a better understanding of under-savers by postulating spending and saving decisions as the outcome of the interaction of two sets of utilities operating within the individual: the doer who cares only about the next time period and the planner who cares about the longer term. Research by McClure et al. (2004) supports that view; impulses to satisfy current desires and to provide for future satisfaction appear to arise in different parts of the brain. The Thaler-Shefrin model suggests improved prescriptions for higher saving for undersavers, such as precommitment to save at a higher rate contingent on future bonuses and increases in incomes. Though promising, these prescriptions have been slow to gain practical implementation.

The life-cycle model deals with time smoothing expected financial resources rather than with growing opportunities in an uncertain world. What happens if you unexpectedly gain enough wealth to meet your previously planned future needs? Should you stop saving? Or should you provide more opportunity for your wealth to grow further so that you may raise your aspirations? Difficulty in dealing with such questions suggests the need for further thinking about the nature of good financial planning.

In the United States, as in many other developed economies, the failure of most people to personally save enough to provide for their old age is materially offset by government-mediated transfer payments. It is easy to see the benefits of social insurance as risk pooling. It is also easy to appreciate the need to provide some compensation for the increased income inequality that appears to have accompanied globalization and ever more complex technology. However, the unintended consequence of the U.S. transfer payment approach is the shifting of the problem of undersaving from the individual to government, with problematic results for society as a whole. The political process is made less functional through greater polarization; those with more financial resources understandably resist efforts to transfer them to those with less. At the same time, a lower savings rate means that needed investments in education, research, capital equipment, and environmental protection may be foregone.

YOUR MOST IMPORTANT INVESTMENT DECISION

How much should you invest in relatively safe cash and bonds and how much in riskier common stocks? How much to other types of investments such as real estate? The exposure to risky investments determines not only how much your savings will be worth on average in a few decades but also how big is the probability of doing very badly, especially if you need the funds to be available in the interim.

All too common is the advice to invest for the average return necessary to meet your future spending goals. This advice generally does not pay enough attention to the possibility of disappointing investment performance or to the possibility of adverse changes in your financial situation. Beyond that, it plays into the hands of those who exploit the common misperception that a riskier investment necessarily carries an expectation of higher returns, as early noted by Dusak (1973) in her study of investing in commodity futures.

Investor questionnaires to determine suitability of investments for the particular investor may be less helpful than they appear. For example, Grable and Lytton (1999) developed questionnaire items that appear somewhat reliable as predictive descriptions of risk-taking behavior. So we know, for example, that the typical male is more risk prone than the typical female. But this fact does not seem to be strongly connected to future financial needs, but instead connected with comfort and personality. That is, it may be good description, but it is not good normative advice. A more elaborate method asks the investor to respond to a simulation of long-term results under different allocations of wealth between stocks and bonds. Again, however, the investor is likely to have a poor idea of how he or she will feel in the future as the consequences are played out.

The most frequently taught approach to quantitative investing, based on the mean-variance optimization method formulated by Harry Markowitz (1959), tells you quite a lot about good diversification given investment characteristics. However, it tells you nothing about how much to invest in stocks versus cash and bonds unless you happen to know your best risk tolerance to achieve your objectives. That is, it begins by assuming you know what you probably don’t know.

In a revealing experiment with university employees asked to allocate retirement funds, Benartzi and Thaler (2007) found that the stock–bond split was very strongly influenced by whether the participants were presented with more bond fund alternatives or more stock fund alternatives. Description of behavior, again, can be a very poor guide to good advice.

Are you persuaded yet of the need for better guidance for risk taking? It gets worse as we move from individuals to institutions, where risk taking is further stimulated by asymmetric rewards. That is, the mortgage broker, the hedge fund manager, the trader, and the corporate executive all take larger risks with someone else’s money because if they win they get rewards much bigger than their loss if they lose. Existing measures supposed to prevent excessive risk, such as the Value-at-Risk (VaR) model enshrined in international banking convention, may instead have promoted it by displacing better measures. It could even be argued that VaR is used more as an excuse for risk taking than as a limitation on it. Some financial executives apparently think it to be a measure of the most you could lose rather than as a measure of the least you could lose with a given probability.

In the absence of strong conceptual frameworks, widely shared, that could be more effectively employed as a check on financial risk taking, the ultimate check against too much risk is the bursting of financial bubbles. The global financial crisis beginning in 2007 and still continuing in 2012 appears rooted in excessive risk taking. The result is not a lack of saving, but rather negative saving in the form of too much borrowing. Reinhart and Rogoff (2009) give us a compelling account of how this most recent example fits into the context of centuries of similar bubbles and their collapses.

If the primary safeguard against excessive risk taking were to continue to be the memory of past traumatic crises, then as memories fade, we would be doomed to repeat the bubble cycles described by Hyman Minsky (1986) again, and yet again.

Diversification, the Only Free Lunch in Investing

Although the popularity of mutual funds and exchange-traded funds (ETF’s) has improved the situation, investors as a whole appear to be substantially under-diversified. Studies by Goetzmann and Kumar (2001, 2007) have found that the average investor in individual common stocks holds only about four different stocks, and that efforts to diversify are typically based more on the number of stocks than on any attempt to look for stocks that have less correlated returns with other stocks. Their research indicated that under-diversification is positively related to the following attributes: youth, lower income, less education, overconfidence, trend following, local bias, and risk tolerance as indicated for preferences for volatility and skewness. A study by Dorn and Haberman (2005) of German discount broker customers found similar factors associated with under-diversification, including self-reported risk tolerance, less experience, less knowledge about financial securities, youth, and being male.

There is some evidence that in the case of bias toward geographically local stocks, and also for a subset of more wealthy, experienced and knowledgeable investors, lack of diversification is associated with higher returns, possibly reflecting better information or investment skill.² However, for the bulk of investors, under-diversification is associated with lower returns.

Perhaps the most surprising under-diversification occurs in context of failing to diversify one’s employment or business-related risks, typically relatively large, with one’s investment holdings. Not only are investments not well-diversified against employment compensation, but they often include a large component of company stock. Benartzi (2001) and Liang and