Tuesday, January 09, 2007

Optimizing, Satisficing, and the #1 Finance Move To Make

Normally, I let my buddy Ramit do the personal finance blogging, but recent events compelled me to write at least one quick post.

Over the holidays, I had dinner with an old friend of mine, a brillant and wonderful man with degrees from Stanford and Yale Law School. He is a partner in a prominent law firm, and one of the smartest people I know.

He confessed to me, "I have $200,000 in cash sitting in my bank account because I'm just not sure what to do with it."

Now my friend is clearly smart enough to know what to do with his money. In fact, the problem is that he is too smart. Like many smart people, he is trying to optimize rather than satisfice his finances.

Satisficing is a crucial concept--it means settling for "good enough" rather than trying to achieve the perfect.

For 34 years, Burton Malkiel has been preaching the values of satisficing in personal finance. All you have to do is to invest your money in low-cost index funds, and wait. As Malkiel notes:

“An investor with $10,000 at the start of 1969 who invested in a Standard & Poor’s 500-stock index fund would have had a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested,” Mr. Malkiel writes. “A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $284,000.”

That, he says, proves both the advantage of index funds and his underlying premise, which is expressed in the book’s title. Stock prices, Mr. Malkiel says, follow a random walk, “one in which future steps or directions cannot be predicted on the basis of past actions.”

This means that “investment advisory services, earnings predictions and complicated chart patterns are useless,” he says. His recommendation is to buy stocks and to hold on for the long term. History shows that you will be rewarded: over time, earnings and dividends tend to increase, driving prices higher.

My advice to my friend was simple: Just put your money into a simple asset allocation fund that splits its investment between stocks and bonds, and stop worrying.

But my dirty little secret is that I realized that I wasn't taking my own advice. Instead, I had constructed a wildly complicated Excel spreadsheet based on value-averaging to split my money between every imaginable asset class in order to squeeze out the best possible risk-adjusted returns.

Naturally, when my life got busy, I failed to carefully rebalance my funds every 3 months, per my model, and I had actually built up quite a cash position myself.

In reality, I too was optimizing, and doing it rather poorly. I'd probably have twice as much money today if I just stopped trying to outsmart myself.

So I resolved to myself to stop worrying about the optimal solution and market timing, and just take my own good advice. Last week, I poured my cash into a simple asset allocation fund, and I plan to forget all about it.

In the end, if you're an entrepreneur, focus on building your company, not managing your money. Pick the good enough solution that lets you sleep at night and spend your time on the things that really matter.

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