Bets, Portfolios, and Belief Revelation
By Bryan Caplan
It’s a mistake that most people make (myself often included!), and that
an intro finance class spends months correcting. The mistake is looking
at the risk and return of single assets instead of total portfolios.
Basically, the risk of an asset – which includes a bet! – is based
mainly on how that asset relates to other assets in your portfolio.
I’ve attacked this idea before, but here’s a better version. Let’s start with two observations.
1. If portfolios really “reveal beliefs,” Tyler and Noah should be able to look at a random person’s portfolio and tell us everything he believes. Yet neither Tyler, Noah, nor anyone else can do this. They can’t even deduce someone’s financial beliefs from his portfolio, much less his beliefs about economic policy or the Fermi paradox. Portfolios say something about beliefs, but every portfolio is consistent with a very wide range of views.
2. Most people’s portfolios exhibit extreme inertia. Even prominent Nobel prize-winning economists admit they follow simple rules of thumb when they invest. So unless people’s beliefs are carved in stone, how could portfolios possibly reveal much about their beliefs? Tyler is a case in point: He changes his mind a hundred times a day, but he follows a simple financial strategy that hasn’t varied in years.
What’s going on? Normal human beings compartmentalize. When they pick a portfolio, they may take their beliefs about inflation into account to some degree. When they explicitly bet on inflation, however, they almost certainly take their beliefs about inflation into account to a massive degree.
How is this possible? The hyper-rational agent model that Tyler and Noah appeal to is deeply wrong. Noah gets close to this truth when he writes:
[I]f you take modern portfolio theory seriously – if you don’t believe in any sort of mental accounting at all – then you’d have to look at my entire financial portfolio in order to determine what I really believe about inflation.
Given the facts, Noah should have reversed his reasoning: “Since mental accounting is plainly a huge deal, portfolios don’t reveal much about beliefs.” If he resists this reversal, I have to ask him, “If even you took months to grasp basic portfolio theory, why on earth do you think that normal human beings conform to it?”
Mental accounting doesn’t just mean that portfolios reveal little about beliefs. Mental accounting also means that bets reveal a lot about beliefs. Since people compartmentalize, the best way to figure out what someone believes about Question A is to focus on Question A. And since people are cagey, the best way to focus on Question A is to press them to bet on A. This isn’t rocket science, just common sense.
Tyler and Noah aren’t totally wrong. Orthodox portfolio theory probably works tolerably well for sophisticated investors, clever arbitragers, and Mr. Spock. As a rule, though, the betting norm is the gold standard of belief revelation. When a normal person refuses to put his money where his mouth is, he’s not being clever as a fox. He’s being shifty as a weasel.