50/40/10 investing

You Can’t Teach Height in Basketball… or Investing

The 50/40/10 Rule and Investing

 

Tell me something… Do you think some people shouldn’t be investing in the stock market?

Not that they are crazy, but just the way they are put together, wired if you will, means that they should stay away from the volatility? You know they are going to blow themselves up or sell low because they are taking so much risk.

You can’t teach height in basketball. Yes, people can and do change, but if you understand yourself, you can set yourself up to be a better investor. Tall people play basketball, but you can’t teach someone how to be tall.

If you are short, you may not want to pick basketball as your sport. Similarly, if you panic or know that you are risking too much, you may want to think about how you are invested.

Do it now, when times are good.

Let’s talk about height and the 50/40/10 rule and investing. But first… are people able to change?

 

Are People Able to Change?

In investing, your personality is pretty much set. Just like your height.

That is, some people are aggressive and like to take risk. They may buy individual stocks, or heaven forbid options, or margin levered ETFs.

And then there are people who are likely to sell when the market tanks (as it does regularly and will always do).

Is your investing personality pretty much set, or are people able to change?

If you know yourself, you might be better able to invest correctly for your investment personality. After all, if you are prone to sell low, investing in 100% equities is a terrible idea. Don’t take stock market risk if you don’t understand that volatility is a short-term phenomenon.

How much control do you have over your investing personality? Let’s introduce the 50/40/10 rule.

 

50/40/10 in Happiness and Investing

Meet the 50/40/10 rule as described in the happiness literature.

This is the idea that, at least with propensity towards happiness, some parts are fixed and some parts malleable.

50/40/10

Above, you can see the basics of this 50/40/10 model.

A full 50% of your happiness is set in stone, or derived from your genetic make-up. This is the 50% of happiness that you cannot control.

Next, 40% of our happiness is due to the internal state of mind which is influenced by your 10% of circumstances. This model implies that we can affect only 50% of our actual happiness! Moreover, the 10% that is circumstantial influences the 40% of how you perceive your happiness.

We all know people who are generally happy regardless of their lot in life, whereas others will never be happy. Sure, you can change your circumstance for the most part, but you still have 50% fixed and the 40% you can attempt to change.

This concept is from “The How Of Happiness” written by Sonja Lyubomirsky. Yes, it is essentially made up, but the point is that we do have the power to change, at least a little. But we best understand the fixed 50% of our personality!

So to review:

  • 50% of happiness is determined by genetics
  • 10% of happiness is determined by the circumstances in which you live
  • 40% of happiness is determined by your actions, your attitude or optimism, and the way you handle situations

 

You Can’t Teach Height in Basketball

So then, 10% of your happiness is determined by what happens to you and 40% is how you respond to it.

The other 50% is just who you are. Like, you can’t teach height in basketball.

If you are tall, you are much more likely to be a good basketball player. Sure, there are short guards and lots of tall people who don’t play, but there is just a massive advantage, all other things being equal, in being tall when playing basketball.

How does this apply to investing?

 

You Can’t Teach Height in Investing

About 50% of you is already set as an investor. No, not set by genetics per say, but it is inelastic nevertheless. How well do you understand that 50%?

For instance, when the market tanks, do you panic sell or do you buy more stocks because they are on sale?

This is really important to understand. Right now, we are at the top of a long cycle of stocks doing really well. The circumstances you find yourself in currently: like shooting fish in a barrel. You almost cannot lose stock picking right now, or trading options. You are AWESOME!

Yet, we all know how this is going to end up. A lot of people are going to lose a ton of money. If you are taking more risk than you should right now, when the music stops, the dance is over.

On the flip side, there are people who will sell low when the market goes down next time. It happens every single time. I’m not making a prediction that there is a correction coming, but understand that corrections and bear markets are a regular and expected part of the market cycle. We just haven’t seen one in a while, so some forget.

Moreover, there are those who should not be invested in the stock market, period, because they are going to commit the cardinal sin in investing and sell low. Is that part of your 50%?

If you are going to sell low, you are actually better off in structured products or heaven forbid annuities with principal protection. As much as I dislike these products (because they are expensive and limit the upside), if they prevent you from selling low, then they are better than cash.

 

The 50/40/10 Rule and Investing

The immutable 50% of your investing personality is the risk you take in investing.

The difference you need to understand is risk tolerance.

Risk tolerance is a key when creating your asset allocation. It lets you not sell when the market takes its normal downturn.

But we know risk tolerance changes during the market cycle. Your “set” risk tolerance is the 50%. Things are going so well right now, however, that the 10% that is circumstantial is all green lights and rocket ships to the moon. This then leads the 40% wanting to go big, too.

So, you might be 100% risk on right now. “Game On Garth!”

When the tide turns, you will be naked. If you have a high set point for risk, make sure you are not too far in front of your water skis.

 

Summary: 50/40/10 in Investing

While the 50/40/10 idea for happiness is not based in science fact, it may be a useful model for happiness and your investing personality.

Remember, 50% of you is essentially set in stone, and you’d best understand it. If you have panicked in the past, you will do so again. If you buy more when the sky is falling, then understand that too.

Because right now, 10% (the situation around us) is all green lights, and the 40% which we can actually control is ripe for FOMO.

I don’t think you can teach the ability to tolerate risk, more than you can teach someone to be tall.

Understand if you are tall then you are more likely to play basketball. If you are short (or have a 2-inch vertical like me) then find another game. Same with your investing personality.

Because it is “Game On” right now in the stock market, which means people are Risk On. They are over-invested, over-leveraged, over-everything and not sticking to the game plan.

Set your asset allocation for the worst possible scenario, and I know you will rewarded when you don’t sell low.

A couple lessons to leave you with:

  • The harder you try or practice in basketball the better you are. This is not true when investing. In investing, your efforts are not only not reward, but usually come at a cost. Your investments are like a bar of soap, the more you touch them the less you have.
  • When we see bad behavior in other people, we think it is their disposition or personality. Conversely, when we ourselves demonstrate poor behaviors, we believe it is due to the situation rather than our personality.

Understand your 50%. It is game-on risk-on right now. Much of how you will act in the future depends on the decisions you are make today. Understand yourself and set yourself up for the real risk that you face in your investments. Your goal: to get the best anxiety-adjusted returns over your lifetime.

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4 Comments

  1. great post! do you think the coronabear was a good test of risk tolerance, of that unmalleable genetic 50% we are born with? If not, how deep and how long or how much should one lose to get a really good test of risk tolerance?

    also, is that supposedly genetic 50% not genetic at all, but biases and heuristics that have helped us survive as a species that when identified, can be used to actually HELP somebody become a better investor? For example, I frame a bear market as “stocks on sale.” I actually have in my written financial to castrate myself if I ever sell low! (seriously, I’m not kidding) to use the salience heuristic to prevent me from selling low. I am a neurologist and sort of fascinated how our brains make us terrible investors, but short of having a stroke or dementia, the brain and cognition is highly malleable and my neurology training tells me that 50% is not really genetic. but do you think that what we are taught as neurologists is only the 40% that is modifiable?

    I agree you can’t teach height, but Spud Webb and Mogsey Bogues still learned to play in the NBA 🙂

  2. Life is full of risk. Education teaches us about probabilities. Therefore our tolerance of risk is really about our management of probabilities.
    Sequence of return risk is a good example. As we approach retirement it is critical that we manage appropriately the probabilities associated with a market downturn. Therefore we increase our bond holdings as we approach retirement then we increase our stock holdings after we retire so that we don’t run out of money! Attempts to time the market is a matter of miseducation.
    However your point about risk tolerance and personality is well taken because risk tolerance is a matter of emotion as well as financial or other probabilities. I believe it is important to consider how we will feel and react under different circumstances so that we may plan accordingly.

  3. That’s an interesting take, and a fresh one. Being an engineer I usually raise an eyebrow over soft science stuff because it is so hard to get accurate measurements on things like how happy someone is. But it does ring very true that we all know people that are always happy and some that are rarely happy and that both types still have varying degrees of happiness depending on circumstances. One thing about risk is how close you are to the edge of the cliff determines how you seriously you view financial risk. If you are set for a 1% safe withdrawal rate to fund a plush retirement, then it is hard to imagine a scenario that will wreck you financially other than the total collapse of our economic system. If you need a 5% withdrawal rate just to meet your bare necessities then normal stock volatility is going to appear like a very realistic risk. I tend to think in that case, the circumstances of having multiple millions in reserve could possibly have a much greater than 10% impact on behavior in a stock market crash.

  4. This interesting post raises a number of profound questions and crosses many disciplinary lines. Alas, I have found most folks are happier with their material needs and wants satisfied, but that their attitudes towards money (alas) vary widely. We all know happy people who are tightwads and cheap and miserable people who are magnanimous and giving. One might think there would be an alignment between “world view” or Zeitgiest and innate investment attitudes or attitudes towards philanthropy, marriage, God, or even patriotism. My totally unscientific conclusion is that there is no specific relationship between the “immutable 50% and attitudes towards money and investments. I would surely find one re career choices and other important decisions, life choices, etc. At any rate, David, your basic conclusion is most sage…..be comfortable in your own skin and approach money matters accordingly. (I told my own burnt out and disgusted PCP to join the VA and find the happiness he craves……) Cheers. Arthur

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