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Subject:  Modeling Investment Choices Date:  11/21/2012  9:19 PM
Author:  trader2012 Number:  34518 of 36322

One of the spin-offs of the unproven hypothesis widely known as ‘Modern Portfolio Theory’ is ‘Investor Profiling’ in which would-be investors make a series of choices and then are directed toward the proper asset-allocation for their personality/life stage. This technique --though mostly as much garbage as its parent-- is highly germane to the discussion I’ve launched in another thread with my nemesis in this forum. But set aside, for a moment, the personalities of the two players and consider just the following choice:

“Would you rather have an investment that offered zero loss, but a limited upside of X (+/-Y), or an investment whose downside was X (+/- 2Y) but whose upside was 2x-4x?”

Forget about the numbers. Just focus on the relationships. In one case, there is no chance you will lose nominal principal and absolute certainty that you will do better than break even. In the other case, you might make decent money, but you might lose a substantial amount as well.

It is highly likely that those who are uncomfortable with financial uncertainty (short-term or long-term) will favor the first choice, and those who are comfortable with short-term financial uncertainly --but very uncomfortable with long-term financial certainty-- will favor the second. In short, crucial to each choice is ‘time preference’, and plenty of experiments in behavioral finance document its reality and consequences.

Now, let's apply these ideas to bond investing. The timid are going to load their portfolios with CDs and such, and they are going to get killed in the long run by taxes and inflation. But in the short term, they can keep every penny of what they invested. The bold are going to suffer far more variable results. Some years, they'll make money. Some years, they'll lose money. Nor will they, over the long haul, always come out a winner. But --on average-- they will. So that's the bet they are making, that by acting like investment adults and deferring gratification now, they will achieve greater gains than the emotionally immature who grab the marshmellow when the experimenter leaves the room. What is the 'marshmellow' for bond investors? The reduction of short-term financial uncertainty.

I'm no more comfortable with the crazy things the Fed is doing, the US Congress is doing, the US State Dept is doing, etc., etc. than anyone else. But I refuse to retreat to the putative safety of cash and cash-equivalents while waiting for things to resolve themselves more toward the halcyon days of the past when CDs offering 8% were available from every corner bank. Now, If you want 8% from fixed income investing --which is merely a break-even rate of return after taxes and inflation-- you've gotta take on risk, a lot of it, and that is a task you're not prepared to do well now if you didn't practice it before you needed to do it.

Yes, in the "good, old days" of interest-rates that might offer a real-rate of return, there seemed to be no need to take on greater risk, and Locicious hammered hard on that point in post after post. But he made the fatal mistake of assuming that 'what was, will be', that cash-managements techniques would always be able to be substituted for a genuine investment strategy. Temporarily, during the days of a booming stock market, fixed-income instruments offered safe and fabulous returns that have now disappeared. They will come again. Nothing lasts forever. Not the good times, nor the bad ones. But it might be a very long wait until the conditions arise in which banks have to again compete for cash by offering decent interest-rates. That's what we're talking about here, a simple suppy-and-demand situation. Under the mistaken assumption that the economy is stalled due to liquidity, the Fed is flooding the economy with nearly-free money. But the economic problem is solvency, not liquidity, and the US can't print its way out of bankruptcy.

How long before they file? Who knows? But who will be hurt more, those sitting in cash and cash-equivalents, or those able to manage the risks of genuine investments? Do you want the certainly of one marshmellow now, or the possibility of two or three later? That's the sum of the argument I have with Lokicious, 'time preference'.
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