Separating goals when you have incompatible investment objectives

Give a child a hammer, says Abraham Kaplan’s Law of the Instrument, and they will discover that everything needs to be pounded. Give an investor a crash course in classical finance theory on risk, and they will see it as an endorsement for poor advice and sub-standard products.

The law of the instrument influences us to use one tool for all purposes and can be summed up with Maslow’s phrase, “If all you have is a hammer, everything looks like a nail.” It is a cognitive bias that involves an over-reliance on a familiar tool. A hammer is not the most appropriate tool for every purpose. Yet a person with only a hammer is likely to try and fix everything using their hammer. We prefer to make do with what we have rather than looking for better alternatives.

The financial market equivalent of Maslow’s hammer is the framework through which we view and measure risk. Classical investment theory distills risk to a simple number, volatility, and through this narrow prism we get a distorted view of the investment landscape.

Mental model of investment risk

A mental model is an explanation of how something works. It is a concept, framework, or worldview that you carry around in your mind to help you interpret the world and understand the relationship between things. Learning a new mental model gives you a new way to see the world. Though this may seem like a lofty ambition for an 800-word article, let me try and provide you with a more nuanced model of investment risk. At best you will interpret advice and investment products in a different light. At worst, it will prompt you to seek advice.

The mental model that views risk as volatility and short-term loss drives us to try to manage it, often with detrimental consequences. Let me pose a question.

Which of the following two objectives is more important in the context of investment decisions you make?

1. Protecting the short-term capital value of your savings or
2. Protecting the long-term purchasing power of your savings.

A significant majority of investors would likely opt for no. 2.

Yet in practice, what I witness from clients making investment decisions is the dominance of objective no. 1. This isn’t just an academic debate. There are real world consequences to this decision-making bias.

Incompatible investment objectives

The truth is that they are incompatible objectives. I cannot protect the short-term value of your savings whilst also preserving the long-term real (after inflation) value of your savings. Conflicting objectives either require the dominance of one in setting overall strategy or the separation of long-term and short-term goals. I will come back to that. First, I want to try and diagnose what the issue is here.

Maybe the dominance of objective number 1 is because there is a fear that short-term losses might actually lead to permanent impairment of capital? That has never proved to be the case. Why is this time different?

Inflation risk

A savvy observer would highlight that inflation in Ireland currently is exceptionally low, so really hasn’t been a risk. Yes at the headline level, that is true, 5-yr inflation reading here is barely positive. But if we look under the bonnet of that measure, what we can see is that it masks some strong underlying price trends in things like, utilities, healthcare, education and leisure. So think of things that you spend your money on, and what you might find is that your personal rate of inflation is potentially much higher than the headline rate suggests.

At the risk of being accused of cherry picking (which this clearly is) the price of a domestic stamp since the Euro launched in 2002 has risen at a compound rate of 7.9% per annum. At that rate of inflation, after ten years a retirees income if it hasn’t grown at all, will buy less than half the number of stamps it did at the start of their retirement. If your expenses double and your capital remains the same, you’ve lost half your money.

Separation of long term and short-term goals

And so, back to the separation of long term and short term goals. I’ve argued that short term capital protection and long-term purchasing power preservation are two incompatible objectives. So what if we separate out these two? If we allocate capital to a liquidity bucket for short term requirements and separate this from the core and satellite parts of the portfolio – which are invested in inflation protection assets - we have a fighting chance of being able to ignore short term losses.

With the right perspective, not every investment problem looks like a nail. If your mental model of risk is focused on short term capital loss, you need to put your hammer down and find new tools.