Altruists should mostly follow standard investment advice

Recently, I’ve been seeing some really bad investment advice floating around the effective altruist community. This has two parts:

  1. Bad arguments for taking extreme levels of risk with money you plan to donate.
  2. 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:

  1. How much risk do I really want to take?
  2. 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.

Advertisements

8 thoughts on “Altruists should mostly follow standard investment advice

  1. While investments should not be risk-neutral, it seems to me that there’s at least a good case to be made for greater risk tolerance in EA. Since EA is a community of people with similar preferences in charities, it’s effectively as if the money is pooled. If the risks are uncorrelated, aggregation should mitigate the risk. If one EA donor loses 100% of their investment, this is not as bad as going broke because other EA donors will make up for it. Thinking of it in terms of the Kelly criterion, you should use a logarithmic utility function, but rather than taking the logarithm of your personal funds, you should take the logarithm of the sum of all EA funds.

    Along those lines, maybe the best strategy would be to have the charitable organizations themselves do the investing. This might be more reliable than word of mouth investment tips among their donors.

    I admit I had not thought of this problem until I read this, so maybe I’m completely off-base.

    Liked by 1 person

    • “Along those lines, maybe the best strategy would be to have the charitable organizations themselves do the investing.”

      There’s something to be said for this, though it requires donors to have faith in charities’ ability to make good decisions for decades to come.

      Like

      • Rightly or wrongly, it seems to be bad PR for a nonprofit to hold a substantial investment proposal. Certainly the Democracy Now types have raked the Bill and Melinda Gates Foundation over the coals for having vested interests in coal or something or another. Also, the assumption that EA’s stand to mitigate their risks by pooling their investments assume that said EA’s, while similar in their philanthropic preferences, are divergent enough in their investing preferences to aggregate out to a pooled portfolio that is substantially more diverse.

        Like

  2. Hey Topher,

    I don’t have a strong view on whether you should leverage altruistic money – I haven’t thought about this issue much.

    I just wanted to note with your personal money, it’s a bit unclear what the “standard advice” is. My guess is that it would be something like 60:40 equities:bonds, with a higher proportion in equities the longer your time horizon.

    But this lacks diversification, and most of the risk comes from equities. Many experts don’t think it’s the best allocation. e.g. From the Bernstein book you mention, citing from a summary:

    “If inflation, you would emphasize gold, natural resources, real estate, and cash, as well as a fair amount of stocks. If deflationary depression like 1930s, you’d only hold long-maturity government bonds. If the world lost confidence in U.S. leadership, you’d want a portfolio heavy in foreign stocks and bonds. Since we don’t know, own as many asset classes as you can, so you can avoid the catastrophe of holding a portfolio concentrated in the worst ones.”

    “The most important asset allocation decision is between risky assets (stocks) and riskless assets (short-term bonds, bills, CDs, money market funds).”

    “The primary diversifying stock assets are foreign equity (40% max) and REITs (15% max).”

    Bernstein’s also in favor of value investing, and agrees that future equity returns are going to be lower than history.

    https://sivers.org/book/FourPillarsOfInvesting

    See other expert recommended asset allocations here: http://mebfaber.com/2013/07/31/asset-allocation-strategies-2/
    http://finance.yahoo.com/news/tony-robbins–ray-dalio-s–all-weather–portfolio-161619133.html

    If you can’t use leverage, I still think it’s better to do something like:

    1. Cash + global market portfolio, with the proportions depending on your time horizon
    2. Then only when you hit 100% exposure and 0% cash, consider increasing the weighting on equities.

    So, yes, someone saving for retirement will end up with mostly equities (internationally diversified), but people with shorter horizons won’t.

    Like

  3. “I don’t have a strong view on whether you should leverage altruistic money – I haven’t thought about this issue much.”

    If you haven’t thought about it much, then I think it was a mistake to reference Brian’s discussion of leverage at all. Finance–especially advanced topics like leverage–is an area where it’s easy to do a lot of damage by talking about things you haven’t thought about much.

    I don’t know how to say this without sounding harsh, but this is a very frustrating discussion for me. I don’t claim to be perfect, I’ve definitely made mistakes talking about finance. But I’ve never used, “oh, I don’t actually have strong opinions here and haven’t actually thought about this much” as an excuse. That is not an acceptable excuse in this situation.

    (Incidentally, though I disagree with Brian, I respect him a lot more in this issue, because he clearly put a lot of thought into this article, and I did learn things from it.)

    “I just wanted to note with your personal money, it’s a bit unclear what the ‘standard advice’ is. My guess is that it would be something like 60:40 equities:bonds, with a higher proportion in equities the longer your time horizon.”

    I agree, but this doesn’t come across clearly in your article.

    “But this lacks diversification, and most of the risk comes from equities. Many experts don’t think it’s the best allocation. e.g. From the Bernstein book you mention, citing from a summary:..”

    The fact that you are citing a summary makes me think you haven’t read the book. I, on the other hand, have read the book. Bernstein in fact agrees that risk-tolerant investors should have more exposure to equities. He recommends a 75-80% maximum exposure to equities for investors with a longer time horizon. Other people recommend a 90% cap. Few people recommend 100% equities–that certainly requires an unusual level of risk-tolerance, I agree.

    Bernstein does also argue that stock and bond returns are likely to be fairly similar going forward. I think he makes good points about expected future stock returns. Unfortunately, his 5-6% expected return for bonds, while it may have looked reasonable in 2002 (when the book was written), is clearly unreasonable today.

    Like

    • Ah OK, there’s two issues here. One is whether altruists should be risk neutral, then the other is when you should use leverage. What I meant is that I haven’t thought much about whether altruists should be risk neutral or not, which I think is fine, because that’s not what the article was about.

      Here’s what I said:

      >There was a bunch of discussion recently about whether altruists should lever up their portfolio if they intend to donate the money later (leverage means taking on debt then investing that money). The conclusion was probably yes [link]. But the entire discussion was focused on whether to leverage US equities. Before you apply leverage, it makes a lot of sense to diversify your portfolio.

      I think this reads as neutral or weak endorsement to the idea of being risk-neutral and therefore using leverage. The main point of the paragraph is that *if* you’re going to lever *then* diversify first. This is actually risk reducing rather than encouraging crazy risk taking.

      Later on I say the following:

      > With the altruistic component, it probably makes sense to be pretty risk neutral, depending on which causes you support. [link]

      This is more of an endorsement, but I still only say “probably makes sense”, and “pretty” risk neutral, which is very different from wholly risk neutral, and note it depends on cause selection.

      With personal money, I was encouraging people *against* taking risk, rather than encouraging risk neutrality. I was also encouraging people to save more into their personal component, reducing their overall level of risk. Both of these points mean that someone following the ideas in the article wouldn’t go broke.

      I *do* however, suggest that if you have a very high risk tolerance (having just said many people are taking too much personal risk) it would be theoretically better to lever the GMP than have 100% equities, but immediately point out this isn’t always possible. Here’s the section:

      > With risk neutral money, if you don’t believe you can beat the market, then a leveraged investment in the global market portfolio is probably the best option. (Or if you can’t take on leverage, overweight towards whichever asset you expect to be highest return, probably equities).

      I agree the point about “if you can’t take on leverage” could be more in your face. I’ve added more discussion later to make it clearer.

      I also take this to be the “expert common sense view”: the portfolio with the best risk-return, ignoring the possibility of beating the market, is the GMP, so the optimal high risk portfolio is a levered version of it. (Also note that because the risk of the GMP is about half equities, the Kelly Criterion *would also* recommend substantial leverage).

      Though I agree it’s not mainstream personal finance advice for small investors – this advice would say overweight equities like I say in brackets. The piece was aimed at people who have already thought about investing a lot (as many of the earning to give people have). That’s why I framed it as ‘common mistakes’ rather than ‘primer to investing’. I wasn’t trying to “reinvent the wheel.” I’ve added a note to further clarify at the start. I agree that a novice should start by trying to understand the standard advice, and then only update away from that if they’re confident they can do better.

      FWIW my impression of the best “standard advice” is that it’s moving away from 60/40 international equities/bonds, towards including real assets, value-tilts and other diversification. People often say diversification is one of the most important ideas in finance (“the only free lunch” etc). So besides the point about levering the GMP if you have have high risk tolerance, I think the other personal advice is in line with the the more sophisticated end of standard investment advice. (except for some of the “advanced” section).

      For instance, the point I was making about Bernstein is that he seems to recommend adding foreign stocks, REITs and real assets as diversifiers. Once you’ve done that, you end up with something pretty similar to the GMP, with a tilt towards equities depending on your time horizon and risk tolerance, which is what I recommended.

      (And that he also agrees with value tilts and my remarks on expected equity returns).

      Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s