We all know what the word maximum means. When we step onto a crowded elevator and we see that the “maximum” weight limit is 2000 pounds, we likely are doing some quick calculations in our head. When we drive down the highway and see the speed limit sign, this also communicates yet another version of “maximum”. In both cases, the term maximum implies the very end of “safe” and the beginning of “unsafe.”
It is certainly part of our American culture to seek the best and the maximum of everything. This aspiration is framed in economics as the Law of Diminishing Marginal Utility. In essence, this says that consumers try to maximize “utility” (utility is a measure of satisfaction or happiness from consuming something), while simultaneously minimizing the cost. This microeconomics theory hinges on two main assumptions: first, that consumers are rational; and second, that consumers are able to calculate the benefits and costs correctly. Let’s examine what this means to a 21st Century investor.
Investors often mimic the overall investing environment around them. That is, in up markets, they often desire more risk and in down markets, less risk. This is emotional, not rational. Trying to precisely plot the allocation required to “optimize or maximize” return for a certain level of risk is fraught with danger from the start. First, markets are dynamic and the calculations are therefore imprecise over time. Second, and more important, maximizing return is very likely not what investors need to fund their long-term goals. For many, managing variability is of primary importance so that the path and plan are kept in place for the long term (i.e. they don’t “panic out” of the market).
Over the past couple decades, behavioral economics has provided us with useful insight into how financial consumers think. While most investors believe that they make rational choices, in many instances these decisions are governed by emotions and biases. These psychological triggers and traps can lead directly to irrational behavior, particularly at times of perceived market stress.
Attempting to make economic calculations to “maximize” returns can cause much more harm than good. Replace the term maximum in your vocabulary with “enough”. That is, what is “enough” risk and “enough” return to fund your personal long-term goals. Ready for a real conversation?