The Butterfly Effect: In praise of suboptimal portfolios

I recently had a chat about the origins of the political misery we find ourselves in. The companion I was chatting with said that he thought the entire Brexit debacle could be traced back to Ed Milliband stabbing his brother in the back in order to become leader of the Labour Party. He argued that this opened the door to the re-election of David Cameron as Prime Minister and with it the Brexit referendum of 2016. The rest, as they say, is history. 

I have heard similar arguments being made about Donald Trump’s run for President. Who knows if Trump had run for President had Obama not roasted him so aggressively at a White House Correspondents Dinner a few years earlier?

Whether there is truth to these views or not, it shows that small actions can have tremendous consequences later on. In science, this is generally referred to as the Butterfly Effect, so named because its discoverer, the meteorologist Edward Lorenz, found that miniscule differences in atmospheric pressure, temperature or some other variable can lead to vastly different outcomes for the weather. The flapping wings of a butterfly can trigger a tornado in the American Midwest.

When I think back to my days in wealth management, I remember vividly that I bragged I could tell what profession an investor has and in which country she resides simply by looking at her portfolio. Most private investors (and too many institutional investors) have both a home bias in their portfolio as well as a tilt towards the industry they work in or have the most experience with. Doctors like to invest in health care stocks and Swiss people in Swiss stocks. Swiss doctors…own a ton of Swiss healthcare stocks.

In a sense, these biases in our portfolios can be understood as a manifestation of the butterfly effect. As investors we are constantly confronted with a large amount of data and a plethora of investment choices. Nobody has the time and mental bandwidth to analyse each stock or fund in-depth. Normal humans thus have to become satisficers as Herbert Simon said. Instead of examining each investment alternative thoroughly, we look at one or two alternatives in detail, then at a few more alternatives with a little bit less scrutiny and so on. Eventually, we become exhausted and stop our examination. If we find an investment that is promising enough, we buy that and ignore the rest. 

This simple heuristic has its value in all walks of life because it optimizes the trade-off between limited resources and a broad range of alternatives to choose from.

But how do we choose which investments to look at first? Arguably, if you have a hundred stocks to choose from, there isn’t an equal likelihood of 1% that you pick each stock. Instead, your selection will be non-random and guided by your experiences. 

If you are a doctor, the drugs you prescribe your patients will likely be manufactured by one of the large pharmaceutical companies. You will have met a sales rep from one of these companies recently and if she was friendly and good-looking enough (and they tend to be very friendly and good-looking for a reason) you will not only prescribe the latest drug of this company more frequently, but also look at the shares of that company before you look at other shares.  

Or you might drive past the factory of a big engineering company on your daily commute. You have no relation to that company, but when you start selecting stocks, you have a small bias towards checking out their shares. This bias often is unconscious and many investors won’t be able to tell you what made them look at one stock or another if you’d ask them. But it has a significant effect on the portfolio.

Researchers from the University of Munster in Germany have shown more than a decade ago that when we select mutual funds, the logo and brand name alone triggers subliminal emotions of fear in our brains. And these emotions, in turn, guide our decision to invest in the fund of one company or another. Small cause, large effect.

The problem is that it is hard for investors to control this butterfly effect. Outsourcing investment decisions to advisers and professional money managers does not necessarily work, since they are subject to their own biases.

And how am I supposed to fight a bias that may start subconsciously? In terms of stock selection one can try to invest in index funds and in terms of country exposure one can try to invest in global index funds. That would eliminate home bias and industry bias, but it also risks that the investor abandons the portfolio after a market setback. As I have argued here, risk is path-dependent and if we don’t understand our investments or don’t trust them, we are more likely to abandon them after a large enough loss.

This is why I have gone from fighting home bias and other biases to embracing them. Instead of trying to force an investor into a portfolio that is “bias-free” but she does not feel comfortable with, I rather build a portfolio that includes a certain level of home and industry bias. The challenge is to “nudge” the investor a little bit into a portfolio that is designed in such a way that these biases do not lead to materially higher risks. A little bit of home bias can be a good thing because it calms investors down when things go wrong. Or as I usually put it: I’d rather have a suboptimal portfolio and a client who sticks to it, than an optimal portfolio and no client.