How Einstein solved difficult problems? He used thought experiments. It’s a tool that uses impossible situations, creates hypnotical scenarios, and tries to think and find solutions. A lot of great thinkers use this method. The purpose of thought experiments is to think wild, push us outside our comfort zone and force us to think about answers which we usually try to avoid.
Let’s use “Thought Experiments” on investing and personal finance.
First thought experiment
Let’s say you become a large equity fund manager but with a twist. You have to do the opposite of what a fund manager’s job is. You have to purposely underperform the benchmark (Nifty 100). i.e. fail on purpose. Do you think you can do this?
Initially, you might think it’s easy. It’s like failing an exam. But as you start building a portfolio of forty to fifty worst stocks. You realize that the job is not as simple as it seems.
The stocks which you pick may turn out to be multi-baggers. Leave aside underperforming the benchmark, you can be the best-performing fund manager for that year. Investment outcome is a combination of luck and skill.
Mutual fund data shows a higher allocation happens in funds that have the best last one-year performance. What do you think these investors are doing? Chasing recent outcomes or process?
While investing, stick to process, not just outcomes.
Though experiments on retirement
Let’s imagine you are in your 40’s. Based on your current income and lifestyle, you think that a corpus of Rs 5 crore is sufficient for your retirement. You are working hard, saving, and investing to achieve this corpus. You get lucky and win a Rs 5 crore lottery. What will you do? Will you stop working & retire?
In the Book “Ikigai” the author explains the concept of “Reason to jump out of bed each morning”. Most likely you will still work, but now you will prefer to work on things which you like. You will work with people whom you respect and value. Or start something on your own but couldn’t do because of compulsions in life.
A healthy run rate of savings & investing gives more freedom.
A thought experiment on safety vs taking a risk
Why is it that despite moving slowly in the story of hare and tortoise, the tortoise wins?
It always happens. People who are slow and steady do well. A fixed income investor has no fancy expectations. He or she knows that the only way to achieve a goal is to save a lot. Despite the low interest, they still somehow manage to achieve their goal post.
Legendary investor Charlie Munger says “the first rule of compounding is to never interrupt it unnecessarily.” The only way one can make sure that they don’t stop or interrupt compounding in equity is by having a sufficient amount of fixed income in their portfolio.
A thought experiment on lifestyle
Let’s imagine you are in your mid 30’s. You get a job in a big city and your office offers you rented accommodation between two societies. In the first society, where most people have a posh lifestyle and in the second society where the building has similar amenities but people here have a modest lifestyle. Which building society will you choose?
First society looks good. Who doesn’t want to stay in a society where things are jazzy and has an X-factor. But then there is a catch. Soon you will start comparing yourself with others and play the lifestyle game.
Nicholas Taleb, a famous author, explains that: “The easiest way to get poor is having rich friends. And the easiest way to become rich is to have poor friends”.
A though experiment on fancy stories
You are watching a cricket T-20 match and you see cheerleaders dancing every time a team hits a four or a six. Do you think they are supporting the team & feel delighted when the team plays well?
In every bull market, you will start getting messages on stock tips, trading ideas, option trading courses, and technical charts, etc. They are cheerleaders in the market. No skin in the game. They know there is no story that excites more than an investment moving up in the shortest period. Most people get caught up in this trap.
Just because someone wears a suit doesn’t make him an expert. Future was always unknown and will continue to remain unknown.
A though experiment on the life you will choose
What life will you choose? A lot of initial success and then a boring life. Or lots of failure and success in the end. Or life with a moderate cycle of success and failure.
The problem with initial success is that it makes you arrogant and overconfident. It makes you believe everything is simple easily possible. From 2003 to 2008, the bull market made many investors extremely confident and made them take more risk than warranted. These investors paid the price in the 2008 crash.
On another hand, continuous failure demoralizes people. It puts people in depression. From 2008 to 2014, the bear market equity gave no returns for almost 6 years.
Asset allocation tries to give moderate returns in all economic scenarios. It prevents irrational exuberance during bull markets and felling of depression during bear markets. It gives you sufficient success to remain motivated and moderate failures to stay invested in the game.
A thought experiment on right asset allocation
You are on the hot seat of Kaun Banega Crorepati or KBC. You have already won the Rs 1 crore prize money. The final question is for Rs 7 crore. You have known the answer but are not 100% sure of it. What will you do? Play or quit?
The final decision is based on regret minimization. It depends on your life situation. For someone, one crore can completely change their life. Their children can go to a better school; they can pay off debt. Leave the boring low paying job and start a small business. For this person, losing Rs 1 crore will be very painful than the joy of winning Rs 7 crore.
On the other hand, for someone who is already rich winning Rs 7 crore is an upgrade in lifestyle. The pain of losing that Rs 1 crore might not be high. But on the other hand, there will be enough regret of losing lifetime opportunity of making Rs 7 crore. The joy of winning Rs 7 crore might be much higher than the pain of losing a crore.
The right asset allocation is based on how sensitive you are to lose. And what are your circumstances in life? Have sufficient equity and fixed income where you don’t regret either way, when markets go up or down.
A thought experiment on international diversification
Let’s say you move to Singapore with your family. You plan to stay with your family in Singapore for a foreseeable future. Will you invest your money only in Indian stocks and mutual funds or diversify your money across the world?
We all have a home bias. It’s difficult to see beyond the home country. India is ~3% of the world market. In other words, 97% of the company’s trade outside of India. Only when one moves out of India they can see a broader picture.
If one is staying in an emerging country, having allocation in developed countries helps in reducing risk in the portfolio. And if one is staying in a developed economy having some allocation to an emerging country reduces risk and enhances overall returns of the portfolio.
A thought experiment on where to spend
You go to Switzerland. You get mesmerized by the beauty and wish you could stay here your entire life. You genuinely believe at that time you will be able to stay your entire life in the snow-capped mountains. What do you think? For how many days you will enjoy the bliss?
An important concept in economics, “Law of marginal utility”. The first slice of pizza tastes great then after every slice, the taste starts diminishing. Most purchases are like that. High-end cycles, vacation homes, fancy club membership.
Spend on things where the taste of the first slice of pizza is the same as the taste of the 5th or 10th slice of pizza.
A thought experiment on how to pay
Covid is over and you finally get a chance to go out for a much need vacation with your family. You have two options to pay for the hotel upfront or pay the hotel during checkout. Assuming there is no risk. i.e. if the trip gets cancelled you get your money back. In which option will you enjoy the trip more.
If you approach this problem as a mathematician both options are equally the same. But if you approach this problem from psychology you are most likely to enjoy the trip if you pay it in advance.
When you pay in advance, you only carry happy memories during checkout. But when you pay your brain goes through an exercise of calculating the benefit vs cost which takes away part of the fun.
A final thought experiment
You get a good bonus. But your colleague got a bonus higher than you and you are now unhappy. You want to buy an SUV because your neighbour has a Sedan. You spend a lot of money on your child’s marriage because you want to gain respect from your relatives who always thought you were unsuccessful in life. Or you gamble once in a while because you want to win the lottery? Are you irrational?
We are not irrational. We are humans. We all have different goals and insecurities. Never judge anyone of their financial choices. It’s always better to step outside one’s conditioning and indulge in these thought experiments to see another point of view, and who’s to say, you may just make a decision that would work out better for you. Always keep looking for a different point of view and come that much closer to getting it right in your spending and investing decisions.
(The author is AVP for Learning & Development at DSP Investment Managers. Views are his own)