Rational choice theory dictates that our decision making process should involve assessing all available options and then selecting the best possible one, or ‘maximising utility’. This model is an example of a sound concept that fails when it encounters the real world. A major critique of this approach came in the 1950’s when Herbert Simon suggested that rather than attempt to make the optimal choice, cognitive and environmental limitations mean that we often ‘satisfice’ – that is make a decision when we find an option that is ‘good enough’ and meets some minimum threshold criteria.
The friction between satisficing and maximising behaviour is interesting when we consider investment decision making. Our natural reaction is perhaps to assume that we should be maximisers and exhaustively seek the best possible outcomes, and there is perhaps a stigma attached to selecting something that is simply ‘good enough’. But should this really the case? I would contend that for many investors attempts to maximise are not only close to impossible, but the constant search for the best option can actually lead to very poor outcomes. There are a number of features about investment choices that make maximising behaviour particularly problematic.
– Too Many Options: Maximisation may prove effective if there is a narrow and well-defined set of options, but in investment it is impossible to perform an exhaustive search across all available choices. The opportunity set is enormous and fluid, and any attempt to ensure that we have selected the best possible option will be ongoing and fruitless.
– Vague Criteria: Successful maximisation is also reliant on their being known and objective quality criteria – is it possible to easily differentiate between different options based on the most important factors? In investment it is incredibly difficult to confidently isolate these criteria and distinguish between distinct choices.
– Wrong Criteria: In the absence of a certain set of meaningful criteria through which we can judge quality, we tend to focus on one woefully inadequate comparative measure – historic performance. We rely on past returns from an asset or investment fund to gauge its quality. This approach is worse than simply ineffective; attempting to select the very best option based on what has been the strongest performer in the past can lead to deeply sub-optimal selections.
– Shifting Criteria: In addition to past performance being the most frequently used but damaging criteria for investment / asset selection, it also suffers from a lack of stability. Not only is it a weak metric for maximisation at any single point in time, but it is also changeable. The random and uncertain movement of markets mean that if we rely on past performance to compare options, our view on what is the best possible choice will be highly variable.
– Switching is Easy: One of the most problematic features of attempting to maximise in an investment context is the ability to switch between options in a relatively ‘frictionless’ and simple fashion. If we allow past performance to dictate our view on what is the ‘best possible option’ we are likely change our mind frequently and act on this by regularly shifting between investments*. Whilst the optical switching costs may be reasonably low, the total cost of lurching between different investments is exorbitant.
For these reasons, the attempt to maximise in investment decision making is highly problematic yet unfortunately common. Performance chasing in asset classes, stocks and mutual funds, alongside egregious overtrading and short termism are symptomatic of investors consistently and unproductively seeking to ‘maximise’ their choices. Maximisation is another of the many investment behaviours that ‘feels’ conceptually right – of course we should be seeking the best possible option – but has severely deleterious consequences.
In addition to the problems of maximisation specific to investment decision making, it has been argued that there are other negative ramifications. Research has suggested that individuals who maximise are likely to suffer lower optimism, life satisfaction and self-esteem[i]. Barry Schwartz also notes that as the range of options expands people’s threshold for an acceptable outcome becomes too high and they are more likely to blame themselves for disappointing results rather than circumstance or environment[ii] – there are so many options available why couldn’t you pick a good one?
If we are always seeking the very best outcome among a multitude of choices, discontent will follow as there is likely to be consistent regret from failing to select the best option[iii]. The randomness of outcomes allied to the sheer range of options in investment means that there will always be new shiny objects to attract us.
For certain types of investor some form of maximisation is inherent in what they do and the service they offer, but these are the exceptions. For most of us attempting to maximise our investment decision making simply leads to value destruction as we chase yesterday’s winners, trade too frequently and live in constant regret that the investments we don’t own are performing better than those we do . Instead of this, we should be content to satisfice. Find an investment plan that is good enough – based on sound principles (around issues like fees, rebalancing, diversification and compounding) and suited to our objectives. Then stick with it.
[i] Peng, S. (2013). Maximizing and satisficing in decision-making dyads.
[ii] Schwartz, B. (2000). Self-determination: The tyranny of freedom. American psychologist, 55(1), 79.
[iii] Roets, A., Schwartz, B., & Guan, Y. (2012). The tyranny of choice: A cross-cultural investigation of maximizing-satisficing effects on well-being. Judgment and Decision Making, 7(6), 689.
* There is also evidence of maximising behaviour leading to choice paralysis. For example, in the famous jam example where more choice led to less purchase decisions, or in pension plans where so many options are offered individuals are reluctant to participate at all because they are unsure of the best choice.