Maslowian Portfolio Theory

📅 Saturday, February 18, 2012

Finally, I finished my PhD. While it was an enjoyable process and I really learned a lot on the way, it felt like ages. I wanted so much to finish the Ph.D. before my second child was born. Now he is almost a year old. A big thank you to my wife, Joanna, for all the support and my gratitude to my promotor, Freddy Van den Spiegel.

Of course, making a Ph.D. is a rewarding experience and it really teached me a lot about scientific work, the scholastic method, coherent investments, etc. … but above all: I’m on a mission.

I’m on a mission to improve advise about investments. I truly and honestly believe that almost all banks, robo-advisers and agents do not a good job.

FINRA in the USA and MiFID in Europe require investment advisers to make clear if they give advice or not and if they give advice they must take into account the educational background and investment goals of the investor. This makes a lot of sense, but at best they do an awkward effort to fit liquidity into an old concept that is void of investment goals.

The main thinking about investment advice goes back to utility functions, and Markowitz' mean variance portfolio theory. This approach has the following issues:

  1. It requires to consider all investments in one portfolio and optimize this. This implies that the house, the shares, the savings account and the cash to buy a sandwich need to be optimized in one bucket. This makes –for humans– no sense. Humans have needs that need to be addressed separately, they need clarity on what is achievable for what goal.
  2. There is only one investment horizon in that optimization. What horizon makes most sense when we put a house that we plan to keep forever together in one bucket with cash we need tomorrow? There is no answer. Typically bankers assume that nor the cash of the house is part of the equation (is not considered as part of the investment portfolio), the apply an arbitrary horizon of 5 years … probably because they see five fingers on one hand.
  3. There is no way to connect this result to reality and investment products in an objective way. In fact, we need the –not so intuitive– concept of “volatility” to make the link. This results in arbitrary matching of a an arbitrary safe portfolio to an arbitrary level of volatility, an arbitrary matching of an arbitrary level of high volatility to a dynamic portfolio and some kind of arbitrary scaling in between.
  4. Most bankers optimize with a forced percentage of risky assets (shares), instead of cash a would be required by the CAPM theory. So, the optimization is arbitrary and subjective.

In summary this is a disaster for a generation. Markowitz' theory works fine when the investor is just gambling with money that he or she does not need (read: “is so rich that he or she never need to worry about subsistence”). This made sense in 1952, when Markowitz wrote his insights down and it was indeed as step in the right dthat irection.

However, today the world is a different place and we are all part of a generation that unlike any before us:

  1. Will see that states will be unable to provide subsistence out of their balance sheets, because of increasing medical costs, increased longevity and decreased natality.
  2. Hence, you will have to invest for your own retirement — this is no longer a choice.
  3. Therefore, millions of people that will invest will not be so rich that they never have to worry about subsistence and they will have to worry about what to spend for what goal. They will have concrete questions like “How much can I spend on this dream holiday and still send my daughter to a good university in 5 years?”

The traditional theories have no answer and the states will have no cash. That’s why I think the sacrifices were worth it. And I apologise to my family, for it is not over, it is merely a start.

Well, we have on the one hand Markowitz' theory that tells to put all assets in one bucket and on the other hand the reality that no-one does so (eg. we haveseparate the descriptive theory, “Behavioural Portfolio Theory” that describes well how people invest: separate buckets for retirement, projects and playing on the stock exchange). As long as this cognitive dissonance exists, bankers and investors alike will be confused.

Maslowian Portfolio Theory (henceforth MaPT)provides a compelling answer: “people are right: one needs different buckets for separate investment goals”. MaPT starts from the the paradigm that investment are not necessarily a goal in themselves, they rather serve to support other goals: the real life-goals such as retiring, send your kid to school, leave a donation to a shelter.

That is the only tricky part. Once we agree with that, the rest is easy. Human needs are already described by Maslow in 1942. While some amendements are proposed to that theory the main point that “needs are separate in nature and that when one of the needs is not addressed it will get mental priority and will make us feel bad” still stands strong. From this automatically follows that the only safe wayt to help people achieve a satisfiable life is to make safe buckets for each and every big life-goal.

As a bonus we get that each and every of those goals sets concrete parameters that can be used to optimize the investment portfolio (eg. we need a sum of X in Y years). This takes the large amount af fiddling out of the equation too!

Well, it makes life a little more complicated for an investment advisor. focussed 1. Today they are all product-focussed. They need tfocussed o start speaking the language of the customer. 2. Today they are focussed on transaction stories like “invest in USA debt” and then a few months later have another story, inciting the investor to switch assets and so they can earn a transaction fee. So, advisors rather should take and advice fee. That is a little more complicated to explain. 3. They need a way to follow up these investments. That is not available yet.

MaPT makes things more difficult and almost postulates a complex and personalised follow up of the investment portfolio. So, it will be necessary to build such a software.