Portfolio management - are three brains better than one?
With the summer here, it is time for some fun. I marvel sometimes at how often we delegate thinking to others, rather than doing the hard work ourselves. A mushrooming of committees and advisors is the inevitable result. Perhaps this is a good idea. After all, two or three heads are better than one to look at difficult problems such as asset allocation, are they not?
Actually, the answer is not quite so simple. Consider an investment committee, consisting of three members, who for the sake of argument we shall call Andrew, Ann and Carol. The three are tasked with allocating assets for a pension fund, and specifically to agree on the relative attractiveness of stocks, bonds and real estate. Depending on the group’s decision, 50% will be allocated to the most preferred asset class, 30% to the second, and 20% to the third. That should ensure diversification, while hopefully benefitting from collective wisdom.
After a discussion on the economic growth outlook, inflation expectations, climate change risks, and other issues, our trio agree to state their rankings of the asset classes, and from there to move by majority decision to a final ranking. The individual rankings are as follows:
Andrew – 1st Stocks; 2nd Bonds; 3rd Real Estate.
Ann – 1st Bonds; 2nd Real Estate; 3rd Stocks.
Carol – 1st Real Estate; 2nd Stocks; 3rd Bonds.
There is a majority in favour of Stocks over Bonds (Andrew and Carol). There is also a majority in favour of Bonds over Real Estate (Andrew and Ann). So, does that give us the committee ranking of 1st Stocks, 2nd Bonds, 3rd Real Estate? Alas no, as we can easily see that there is also a majority in favour of Real Estate over Stocks (Ann and Carol).
We need to engage the two hemispheres of our individual brains when making investment decisions, integrating analysis with creativity as we grapple with uncertainty.
After much head-scratching and a long lunch, the committee recommends that the final decision is delegated to a sub-committee, as they cannot agree on an answer.
In fact, our poor committee ought not to be depressed. At least since the time of the Marquis de Condorcet in the 18th century, problems with voting systems have been known. Our simple example is a reminder that majority voting may not yield a consistent group ordering, and indeed that there may be no majority winner at all. It also hints that things are often not as simple as they may appear. Reality is complex, embedding enigmas and paradoxes that we cannot ignore.
In an earlier post, I argued that half a brain is not necessarily better than no brain at all, especially if it leads to a narrow microscopic lens blinding the wider telescopic panorama. We need to engage the two hemispheres of our individual brains when making investment decisions, integrating analysis with creativity as we grapple with uncertainty. To add to the story, I now suggest that many brains may not always be better than one, especially if they filter out important complexities, magnifying half-baked thinking rather than diminishing it.
The theme has implications well beyond investment committees, spanning everywhere from government panels to corporate boardrooms. The best advice – beware of over-simplification and engage the imagination when deliberating on complex issues. Sapere aude (loosely translated ‘dare to be wise’), as Immanuel Kant might have put it.
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The blog does not aim to give investment advice, but is designed to afford relevant longer-term context to investors, encouraging a broad perspective where uncertainty is high and a spirit of learning is important. The views expressed are those of the author, not those of Investec.