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  • Writer's pictureDoug Burns

Judging Decisions

As investment advisers and financial planning professionals, we are often making decisions in tandem with our clients about their futures. When judging decisions, we are all susceptible to judging the decision by its outcome. We believe this viewpoint is not the best way to judge past choices.

To give a quick example, if I were to go out to the local convenience store and purchase a “Mega-Millions” lottery ticket, most would question my decision. However, if I was so fortunate to win the jackpot, many would state it was a great decision to have bought that ticket!

Despite the fact that I would probably never have to work again, I would argue it was still a bad decision at the time, despite the tremendously fortunate outcome.

To illustrate, the odds of winning the jackpot (matching all 5 numbers plus the “mega ball”) is approximately 1 in 302 million. If this hypothetical jackpot is $302 million after-taxes and no other smaller prizes are available, the expected return from that purchase is calculated as $1.

The simple math of calculating this expected return is:

  • Expected Return E(r) = Probability of winning the jackpot x Expected value of the jackpot

  • E(r) = P (jackpot win) x V (jackpot)

  • E(r) = 1/302 million x $302 million

  • E(r) = $1

Since tickets cost $2, the expected return of the purchase is an economic loss of $1 (this expected return could actually be argued that it is lower, because more than one winner can be announced, forcing a split of the jackpot). This should not be considered a “good” economic decision because I am expecting a loss.

Instead, we believe decisions should be judged based on the information available at the time the decision is made. Since the expected return from buying a ticket is negative, it should be viewed as a poor economic decision, but can have an extremely lucky outcome.

In our role as financial advisors, we are often guiding clients in the decision of risk allocations for their portfolios. The risk allocation is a function of the client’s need to take risk and our subjective view on their ability to endure risk through market cycles. Once the decision is agreed upon, together we must then decide when to implement the portfolio.

As our clients know, timing the markets is very difficult, if not impossible to do accurately on a consistent basis. Therefore, we usually make implementation decisions based on judging the expected return of the portfolio versus the alternative, which is often keeping the funds in cash. Since the “real” expected return of cash, which refers to the inflation-adjusted return, is often close to zero, implementing or rebalancing a portfolio is usually the right economic decision.

When a portfolio is implemented, there is always a risk that it precedes an undesirable market event. Although it may be the “right” economic decision (all else equal), it may not have the most desirable outcome.

At BPC Advisors, we partner with our clients to help determine the best approach for their situation knowing the advantages and disadvantages of the methods of portfolio implementation. When doing so, we should be mindful that “good” decisions can have sub-optimal results. The converse may also be true for “bad” economic decisions having favorable outcomes, like the hypothetical lottery win. Note: For the record, neither of us has won the Mega-millions jackpot.

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