Preserving your investment bandwidth
- December 27th, 2013
Or how index-centric investing is like the Atkins diet.
One of the key ideas in the new book Scarcity: Why Having Too Little Means So Much by Sendhil Mullainathan and Eldar Shafir is that we all have limited bandwidth. The idea being that scarcity, in all its forms, affects our ability to make decisions. They write:
Because scarcity taxes bandwidth, a key concern in the management of scarcity is to economize on bandwidth. Just as the busy are concern with every minute of the day, and the poor focus on money, everybody under scarcity is profoundly influenced by how their bandwidth is distributed and spent.*
When our bandwidth gets taken up it has a tendency to make us humans more impulsive. Cass Sunstein in his review of the book writes**:
A depletion of bandwidth also reduces people’s capacity for self-control. After being asked to try to remember eight-digit numbers, people are more likely to be rude in difficult social situations. The general lesson is that when people’s attention is absorbed by other matters, they are more likely to yield to their impulses. With this lesson in mind, Mullainathan and Shafir insist that certain characteristics that we attribute to individual personality (lack of motivation, inability to focus) may actually be a problem of limited bandwidth. The problem is scarcity, not the person. Compare a computer that is working slowly because a lot of other programs are operating in the background. Nothing is wrong with the computer; you just need to turn off the other programs.
So how does this apply to investing? The fact is that we are all bandwidth-constrained in today’s modern world. There is only so much time in day to devote to career, family and other interests. Investing for many people is viewed, at best, as another unwanted obligation. In my book I talked about ‘decision fatigue‘ and its affect on our investment decision making. This idea is probably better explained by our ‘limited bandwidth.’
That is why simple rules with limited trade-offs often make for more sustainable outcomes. Mullainathan and Shafir use the Jewish Sabbath and the Atkins Diet as examples of simple rule sets that people are able to put in place to reach their preferred outcomes. They write:
The Atkins diet (in its many incarnations) helps resolve this problem. Instead of constant trade-offs, it imposes a very small budget for carbohydrates. This makes some choices quiet easy: some foods are so low in carbs that you can eat them without trade-offs. It makes other choices-a very big dessert-a virtual impossibility because they simple have too many carbohydrates. This leaves some room for trade-offs-a small dessert of a few slices of bread-but far less than in a standard diet. Now, there are those who are not convinced the Atkins diet is particularly good for you. But psychologically, it has one distinct advantage. Instead of having to ration your caloric intake and calculated at every meal what you would do, the Atkins diet is closer to the Sabbath, with its simple prohibitions and very few trade-offs.*
So for investors what constitutes a simple set of rules with limited trade-offs that provides a coherent investment management plan? One obvious one is follow a low-cost, index-centric globally diversified asset allocation plan. By limiting your investment choices to low cost index funds, open-end or exchange-traded, you have in one fell swoop eliminated a broad range of potential investments. These include:
- Actively managed funds;
- Individual stocks;
- Futures and options;
- Hedge funds;
- Private equity funds;
- Venture capital funds;
- Angel investments;
- Real estate investments;
- and pretty much anything sold by a broker these days.
Your investment palette is now pretty clean. Therefore building a globally diversified, low-cost portfolio is almost a trivial endeavor. That is in part why we are seeing the rise of so-called ‘robo-advisors‘ that provide this type of service online and algorithmically. However just because you can build a portfolio easily does not mean you are done. The market is going to tax your ability, psychologically, to maintain your investment approach.
One could argue that such a bare bones approach to investing provides too few opportunities to express your knowledge and interests in potential alpha-generating opportunities. There are cases in which a low-cost actively managed fund may make more sense for an asset class in a broadly diversified portfolio. Others might argue that holding out a part of their portfolio as ‘funny money‘ provides them with an outlet to invest actively while maintaining the vast majority of their holdings in the manner laid out above.
We are all taxed psychologically in today’s modern world. For the vast majority of investors an approach with a simple set of rules that also minimizes trade-offs provides the best opportunity to keep their portfolio on track. Your bandwidth is a precious commodity. So taking a little bit of time to think about how you can preserve it through a streamlined investment approach is a worthwhile investment in and of itself.
*page(s) 215 and 218, Scarcity: Why Having Too Little Means So Much by Sendhil Mullainathan and Eldar Shafir.
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