Investment philosophies: maximize or satisfice?
- August 16th, 2013
What is your investment philosophy? Think quickly, close your eyes and now write down what you came up with. If you didn’t come up with something pretty quickly it is likely you are investing by the seat of your pants.
Josh Brown at The Reformed Broker stirred up a debate in a recent post looking at the strong feelings some investors have for passive investment strategies. I also weighed in the topic as well. Underlying this discussion is the need for investors to have some sort of overarching investment philosophy, whatever it may be. The point being that different types of philosophies can work for different kinds of investors.
Christine Benz at Morningstar notes that investors should follow three steps in formulating their investment philosophy. First “know thyself,” second “write it down” and third find a community of like-minded individuals. In the end though the success of your investment philosophy will depend on your following that system religiously. Benz writes:
The reason multiple philosophies can work out well is that inherent in having a philosophy, or belief system, is that you have conviction in it. And if you have conviction in something–whether it be central tenets you use to oversee your investment portfolio, your religion, or your belief that Morgan Freeman is the world’s greatest actor–you’re more likely to stick with it in good times…
That is not to say that you shouldn’t modify your investment philosophy over time but changes should be driven by data not by market whims. Tom Brakke in a piece at the research puzzle whittles down this investment philosophy debate about passive vs. active to a key decision. Are you a maximizer or a satisficer? Brakke explains:
Should investors always and everywhere be satisficers, using simple allocations and indexation strategies? Not necessarily, but that is a convenient base case with which to compare other alternatives — and not an imprudent choice under most conditions.
But the business of investment management is fueled by maximizers: Clients desperate to find the “best” managers, and investment decision makers eager to produce performance that brands them as such. (The management firms, of course, are busy trying to maximize assets and fees.) The results have been, for the most part, uninspiring — and certainly a letdown in light of all of the effort expended.
The need for investors to have some sort of succinct investment philosophy that they can write down and follow in a consistent fashion seems self-evident. However before you formulate your plan you need to ask yourself whether you are a maximizer or satisficer. The active vs. passive debate really hinges on how you answer this question.
For the vast majority of investors following a simple, passive investment strategy is the best opportunity to both generate above-average returns with the least amount of investment in time and energy. Some investors have the wherewithal to try and follow a maximizer-type strategy. The ongoing challenge is coming up with a strategy that can both beat the market and be followed over time.
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