Reasonable > Rational

Blog post #465

As investment and financial advisors, we often say that we are rational and not emotional, as we provide you with advice. We hope that is accurate, as we provide you with financial advice on the various matters that you deal with throughout your life.

As I continue to read The Psychology of Money, by Morgan Housel, he raises the concept of being rational v. reasonable.

As much as I have written in the past about us being rational….and striving to provide you with rational advice, I think that it is better to be reasonable, than to be completely rational.

Rational may mean that we only deal with the numbers, the hard facts of a situation or portfolio decision. Being rational may lead one to think that there is only one correct answer to some issues. Being rational may mean that advice and decisions should be made strictly based on only the facts and numbers.

Being strictly rational is not always realistic. People have emotions and attitudes….and these must be factored into our advice and your decision making. The world is constantly changing. Many decisions are gray, not clearly A or B. I don’t think we as a firm have provided advice that has been strictly rational, but thinking about “rational v. reasonable” provides some very good insights about each of our relationships with money.

During the financial crisis in 2008-09 and again during the major decline in February-March 2020 at the onset of COVID, nearly all our clients adhered to their asset allocation plans. That means that we, and our clients, were both rational and reasonable, as we had worked with you to set an allocation to stocks that we thought was both financially proper for your long-term financial interests and goals, as well as a stock allocation you could stick with during good and bad times.

However, for those clients that could not stick to their stock allocation and talked to us about making changes, we worked with them to make changes and develop what was reasonable for them during that time period. It is more important that you can sleep at night, as long as you don’t make financial decisions that we think would impair your financial future.

Since the onset of Covid, we have also had discussions with some clients who wanted to re-evaluate their asset allocations. Some have reduced their stock exposure, as we (us and the client) realized they did not need or want to take on as much stock market risk as they had. This is being both rational and reasonable.

The expected future returns for stocks is greater than the expected future returns for bonds (fixed income). Over the long term, you should expect to create much more wealth by having a 100% stock portfolio than a 60% stock /40% fixed income portfolio. A 100% stock portfolio may be rational based on financial history and data, but it is not reasonable for most people to endure and live through. Thus, we provide reasonable advice so that you can reach your financial goals without enduring the extreme volatility that would come with a 100% stock portfolio.

Past financial history teaches us that over the long term, meaning decades not years, small company stocks outperform large company stocks, International stocks outperform US stocks, and value stocks outperform growth stocks. Based on past history, and the assuming the same expected differences in future returns, it would be rational to structure a portfolio with the highest expected returns. This would mean structuring a portfolio consisting of primarily the smallest value company stocks in International and Emerging countries, as they have the highest expected future returns.

Such a portfolio, with the highest expected future returns could be considered rational, but not one we would recommend, as its not reasonable. Very few investors would be able to stick with such a portfolio.

As we have all experienced, markets and asset classes are not predictable. Asset classes may have expected future returns, but actual returns do not always show up in a consistent manner. Like with other financial recommendations that we provide to you, we recommend portfolios that make sense (are reasonable). And sometimes we change or adjust our recommendations and advice, as the world and financial markets change.

We rely on broad diversification among many different types of asset classes to develop reasonable portfolios. We still believe that factors such as small company stocks, value stocks and global diversification will provide long-term financial benefits. We structure portfolios that include these asset class factors, but importantly we recommend including other asset classes as well, so your stock portfolio will benefit from growth and value, large and small companies. This should help you reach your long-term financial goals and maintain your lifestyle (and be able to sleep well too!).

We feel that being broadly diversified for the long term is both reasonable and rational. Just as the “all small value company International portfolio” is not reasonable or rational, we do not think for most people a US Large company-only portfolio (such as the S&P 500), would be rational for the long-term. It may be reasonable for some, but we would not recommend it for the long-term.

Having a portfolio that you can adhere to and stick with through all kinds of financial markets and future events is most important. That is both rational and reasonable.

We look forward to providing you, and others that you care about, with reasonable advice that is also reasonably rational!

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