Recently, I’ve been seeing some really bad investment advice floating around the effective altruist community. This has two parts:
- Bad arguments for taking extreme levels of risk with money you plan to donate.
- Needlessly re-inventing the wheel in the area of personal finance, making mistakes along the way.
Instead, I think most EAs should follow standard investment advice, by which I mean the kind of advice you will get in books like Burt Malkiel’s A Random Walk Down Wall Street and William Bernstein’s The Four Pillars of Investing, or from the typical econblogger (for example), or from the good people at Vanguard.
(As an aside: I would advise caution about taking financial advice from anyone in the business of providing financial services, given the conflicts of interest that entails. However, although Vanguard is a mutual fund company, their unique customer-owned structure gives them unusually good incentives to do what’s best for their customers, and their fees are consistently the lowest in the business.)
I do not claim this approach is right for everyone. In particular, it may not be the right approach for people with unusually high net worth and/or levels of financial expertise. But I do think it is right for, say, the typical non-profit employee or Silicon Valley software engineer.
The standard advice, in a nutshell, is that you should invest in some mix of stock and bond index funds. You should lean more towards stocks if you have more tolerance for risk, and more towards bonds if you have less tolerance for risk. And yes, diversifying internationally is a good idea.
Combine the above points with the fact that you can generally take more risks the further you are from retirement, and you get Vanguard’s target retirement funds. Wealthfront, which I currently use, provides a slightly more complicated implementation of the same basic concept.
Now let’s talk about the first issue I brought up in the introduction: bad arguments for excessive risk-taking. The claim is that you should be risk-neutral with money you plan to donate, and therefore be willing to do things even riskier than putting 100% of your money in stocks.
When deciding whether to pursue a particular risky investment, there are two questions to ask:
- How much risk do I really want to take?
- Will I be adequately compensated for taking on these risks?
Question (2) can be very hard to answer. I’ve previously argued that startups may no longer offer founders and investors good risk-adjusted returns. But in this post, I’ll try to steer clear of those questions.
Instead, I’ll focus on the relatively simple example of leveraged investing, i.e. investing with borrowed money (or using derivatives to the same effect). Leveraged investing has recently been advocated by Brian Tomasik, and some people have gotten the impression that the EA consensus is you should make leveraged investments with money you plan on donating.
In theory, the problem of leveraged investing is simple, because leverage is supposed to multiply gains and losses equally. In reality, this is only true if you can borrow money cheaply, but the simplified “cheap margin” case is worth thinking about. If you are truly risk-neutral, in the cheap margin world, you should use as much leverage as other people will let you get away with when investing money you plan to eventually donate.
If you know anything at all about finance, alarm bells should be going off. “Use as much leverage as other people will let you get away with” is generally not considered sound financial advice. But it can sort-of be defended in an altruistic context, via arguments that it’s better to have a 20% chance of saving 100 lives than a 90% chance of saving 10 lives, and too deny that is sheer irrational loss aversion.
But if we continue to think about the implications of true risk-neutrality, they get even weirder. Suppose you were truly risk-neutral, and also a competent professional gambler and/or investor, meaning you can reliably identify positive-expected value bets even after accounting for adverse selection. Being completely risk-neutral, your only goal is to maximize the long-run expected value of your bets. What do you do?
The answer to this question is counter-intuitive, and it took me several months of reading and thinking about the issue to understand the answer. But–if you make all the assumptions in the last paragraph–the answer is that you should repeatedly bet every every penny you have on the highest expected-value bet you can possibly find, even when the bet carries a substantial risk of losing everything.
If this sounds like a good way to go broke, it is. Given a sufficient supply of positive-expectation but risky bets, you are virtually certain to go broke in short order.
This is counter-intuitive, because it seems like a terrible way to maximize the long-run expected value of your bets. However, as you look out over your possible futures, you will see ever tinier odds of ever more ridiculous payouts–payouts whose ridiculous size outweighs the small chance of achieving them in expected-value calculations.
Virtually guaranteeing your own bankruptcy seems bad. In fact, I’d argue it is bad–especially if everyone else in your social movement is doing the same, so that if you go bankrupt they probably will too. I mean, forget about the most extreme thought experiments here–it would be bad, for example, if Dustin Moskovitz decided gamble all the money he was planning on donating to Good Ventures on a single business idea.
So instead of “maximize the long-run expected value of your investments”, let’s try tweaking our goal a bit: “maximize the long-run expected value of your investments while minimizing the chance you go broke.” It turns out we can mathematically specify exactly how to do this: it’s called the Kelly criterion.
What does the Kelly criterion say about leveraged investing? Ed Thorpe, a mathematics professor who gained fame and fortune as a a hedge fund manager and blackjack player, once wrote a paper addressing this question. He concluded that if you’re using the Kelly criterion, you should borrow 17% of your portfolio’s value to invest in more stocks.
This is much less leverage than you will get from buying a leveraged exchange-traded fund (which is what Brian Tomasik has advocated). Furthermore, Thorpe assumed the ability to borrow at the same interest rate paid by T-bills, which nobody except the federal government can actually do and most people can’t even approximate.
So for people without access to cheap margin, 100% stocks is probably about as much risk as you should take, even with money you plan on donating. For money you do plan on donating, putting it in Vanguard’s total world stock fund looks like a good choice.
It might seem surprising that sophisticated mathematical analysis would lead to as simple of a strategy as investing all your money in the stock market but not using leverage. But maybe it’s not so surprising. Just by investing in the stock market, you’re already using leverage, in a sense.
This is because corporations borrow to finance new investment all the time. If it were easy to boost returns with leverage, it would suggest corporations aren’t borrowing enough. Furthermore, some corporations specialize in highly leveraged investments: we call these corporations “banks”.
If we step into the world of cheap margin for a moment, it might be possible to improve on Thorpe’s 117% stock portfolio. How? By buying a buying a diversified portfolio of stocks and bonds, and applying leverage to get stock-like returns with less risk. This appears to be basically what hedge fund giant Bridgewater’s All-Weather Fund does.
My guess is that this possibility is probably not relevant to small retail investors, but might be relevant if you have a seven-figure sum (or more) to invest. How much money you have matters because the more money you have to invest, the easier it is to get cheap margin (see Interactive Brokers for an example).
The difficulty of getting sufficiently cheap margin as a retail investor is probably why very few financial advisors recommend leveraged investing to ordinary people. So while there are exceptions, I maintain that most people should just follow the standard advice.