The Missing Billionaires

You can't do much better than using Expected Utility as your summary statistic for comparing spending policies.

You can't do much better than using Expected Utility as your summary statistic for comparing spending policies. Utility over wealth. Expected Utility is a powerful framework for making financial decisions that considers both the potential monetary outcomes and an individual's risk preferences. Unlike simply maximizing expected wealth, which can lead to dangerous and nonsensical policy recommendations, Expected Utility helps balance the desire for higher returns with the need to manage risk. Practical application. To use Expected Utility: Define your personal utility function, typically using Constant Relative Risk Aversion (CRRA) Estimate the probability distribution of potential outcomes for each decision Calculate the Expected Utility by weighing each outcome's utility by its probability Choose the option with the highest Expected Utility This approach allows for more nuanced decision-making, accounting for factors such as decreasing marginal utility of wealth and individual risk tolerance. It provides a consistent framework for evaluating various financial choices, from asset allocation to spending policies.

In investing, the natural tendency is to focus on the question of what to buy or sell. Nearly 100% of the financial press is dedicated to this question, so it's reasonable to suppose that the "what" decision is the most important thing we should be thinking about. It isn't. Position sizing matters. The size of an investment position often has a more significant impact on overall portfolio performance and risk than the selection of individual investments. This concept is frequently overlooked, with most investors and financial media focusing primarily on which assets to buy or sell. Key principles: Optimal bet size increases with expected return and decreases with variance The Merton share formula provides a useful rule of thumb for position sizing Diversification is crucial for managing risk Avoid over-concentration, even in seemingly attractive investments Proper sizing helps manage risk while capitalizing on opportunities. It allows investors to participate in potentially profitable investments without exposing themselves to undue risk. Even great investments can lead to poor outcomes if sized inappropriately, while well-sized positions in moderately attractive investments can contribute positively to overall portfolio performance.

Believing that the expected return of the stock market changes over time is not at odds with a belief in market efficiency. Adapt to market conditions. Dynamic asset allocation, which adjusts portfolio composition based on changing market conditions, can significantly outperform static strategies over the long term. This approach recognizes that the attractiveness of different asset classes varies over time due to changes in valuations, economic conditions, and other factors. Key components of dynamic allocation: Use metrics like cyclically adjusted earnings yield to estimate expected returns Consider the relative attractiveness of stocks versus…