Math Doesn’t Matter

“Everyone has the brainpower to follow the stock market.  If you made it through fifth grade math, you can do it.” – Peter Lynch

We often hear financial advisors and investment strategists use statistical terms like standard deviation, co-variance matrix, efficient frontier and risk-adjusted returns (I’ll even admit to using some of these terms myself from time to time as well) to explain portfolio management.

But most individual investors couldn’t care less about the historical volatility of their Monte Carlo portfolio simulation and the different standard deviations or probabilities that they spit out.

They care about their goals; paying for college for their children, saving for a down payment on a house and being able to comfortably retire someday.

And as interesting and intelligent as using mathematical formulas and theories can sound when discussing your investments, they don’t do you any good, especially if you can’t control your behavior.

Here’s a great story from the New York Times about a Nobel Prize winning economist who basically invented modern portfolio management theory and his view of using his own complex math for his investment plan and asset allocation:

“There is a story in the book about Harry Markowitz,” Mr. Zweig said the other day. He was referring to Harry M. Markowitz, the renowned economist who shared a Nobel for helping found modern portfolio theory — and proving the importance of diversification. It’s a story that says everything about how most of us act when it comes to investing. Mr. Markowitz was then working at the RAND Corporation and trying to figure out how to allocate his retirement account. He knew what he should do: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” (That’s efficient-market talk for draining as much risk as possible out of his portfolio.)

But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.” As Mr. Zweig notes dryly, Mr. Markowitz had proved “incapable of applying” his breakthrough theory to his own money. Economists in his day believed powerfully in the concept of “economic man”– the theory that people always acted in their own best self-interest. Yet Mr. Markowitz, famous economist though he was, was clearly not an example of economic man.

Markowitz pioneered the mathematical foundation for determining the ideal risk and reward relationship you should have in your investment portfolio.  This is a widely used theory in the portfolio management industry and for good reason.  Determining the correct asset allocation that maximizes performance at your given risk tolerance is the goal.

Yet he still felt that his behavioral biases trumped those equations so he kept his asset allocation as simple as possible.

A similar story has to do with the early days at Google when they were taking the company public and most of their young employees were facing the prospect of having enormous amounts of wealth from their stock options.

A senior Google executive actually set up a few weeks worth of investment seminars to educate their employees on how to invest their money before they would let Wall Street come calling to offer them complex products with extremely high fees (one of my favorite parts of the story).

Here’s one of the best pieces of advice they received:

One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought much about. First to arrive was Stanford University’s William (Bill) Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his “gradient method for asset allocation optimization” or his “returns-based style analysis for evaluating the performance of investment funds.” But he spared the young geniuses all that complexity and offered a simple formula instead. “Don’t try to beat the market,” he said. Put your savings into some indexed mutual funds, which will make you just as much money (if not more) at much less cost by following the market’s natural ebb and flow, and get on with building Google. 

The Sharpe Ratio, which calculates the risk to reward ratio on investments and is widely used in the finance industry today, was named after William Sharpe.  But even he advised the brilliant employees at Google to keep things simple.

For those of you not working at Google, I would substitute ‘get on with building your life’ at the end of his speech and use the same approach.  Focus on what matters.

The greatest asset allocation formula or “sure fire” algorithm-based investment strategy won’t work if you can’t control your behavior.  That’s one of the biggest benefits of keeping your disciplined investment strategy as simple as possible.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment de jour.  And basing your decisions on complex mathematical formulas won’t keep you in your plan when turmoil hits.

This is one of the reasons that Dave Ramsey’s debt snowball approach works so well when paying down debt.  It’s not the smartest choice on a mathematical basis to pay down your smallest debt balance first.  You would do much better for yourself on an absolute basis by paying down your highest interest rate debt first since you would see the biggest interest rate savings.

But people see early results from the debt snowball and that helps give them the motivation and momentum to stick with it.  It helps people keep their behavior in check to get out of debt.

Whether it’s paying off debt, creating your investment plan or your monthly budget, taking a simple approach that focuses on controlling your behavior and emotions is the best way to ensure long-term success.

Our finances are about emotions and behavior, not math and calculations.

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  1. My Own Advisor commented on Jul 18

    Thanks for including me in your roundup of reads. I need to check out a few of these articles 🙂