When we think about investing, it is often transactional, dry and not much fun. The traditional image is of a rational investor sitting in front of a screen, using some obscure calculations to determine where the most money can be made with the least amount of risk. We call this Modern Portfolio Theory (MPT), with all its finance jargon like efficient frontiers, variance and correlation, and the statistical analyses such as the Sharpe ratio and the Treynor ratio, measuring risk-adjusted returns.
Bored yet? Maybe it is just me, but I am not just bored, I’m also annoyed. The limitations of this theory are so significant I find it hard to believe so many smart people continue to think it is a good idea.
For one, we are not rational beings – even those who claim they are. As behavioural economist Dan Ariely articulated in the title of his brilliant book, we are ‘Predictably Irrational’. Daniel Kahneman, one of Ariely’s mentors, even won a Nobel Prize in economics for sharing this insight.
We are emotional beings, influenced by our upbringing, our desires, our egos, our relationship to risk and our relationship to returns. Our psychology around risk and return is a powerful force which almost guarantees that the mathematical analysis of MPT will not play out in the real world.
A simple example of this is how we measure and react to risk. Consider how much is invested globally on preventing terrorist attacks, including all the airport security measures and our huge military and intelligence budgets.
Now compare this with the investment in prevention for heart attacks – note that we spend an extraordinary amount on treating heart disease, but not very much on prevention. We wildly miscalculate those risks, even when we have good data. Heart disease kills around 18 million people each year, whereas over the past decade, terrorists killed an average of 26,000 people worldwide each year.
The problem with Modern Portfolio Theory
The problem with Modern Portfolio Theory is that it does not take into account who we really are and what we really value. Firstly, humans are not rational beings chasing maximum returns at minimum risk. We have different, and mostly warped, understandings of risk and almost everyone I have ever met has a somewhat messed up relationship with money. If that was not true, everyone’s portfolios would look the same, and we would not get the booms and busts we are so familiar with. We also wouldn’t jump out of aeroplanes, drive fast cars or fight in wars.
Ultimately, the main issue with MPT, and the mainstream finance system as it is today, is that it does not serve us and our highest values. The consequence of a narrow-focused finance system is that many of the things we care most about are ignored or, in finance speak, externalised. Love, nature, relationships, joy, health, kindness, adventure, hope, service, friendship.
In our attempt to put a price on some things, we forgot the value of everything else. The question we need to ask of our economy is, ‘why?’.
Beautiful Portfolio Theory
Consistently interrogating the ‘why’ has led me to Beautiful Portfolio Theory, which adds a third leg to the traditional, unstable, two-legged stool of Modern Portfolio Theory. The third leg, or rather the first leg, is impact, and it is the lens through which all investments should be made. Here are three reasons why I am sure of this:
- If we do not focus on the environmental impact of our investments and the economy, we will disrupt our planetary life support systems and cause unthinkable damage to everyone and everything we love and care for.
- If we do not focus on the social impact of our investments and the economy, we will continue to exacerbate the gap between the haves and have nots, add to the suffering of the vulnerable and disadvantaged, and ultimately lead to social and political unrest and violence (read: war).
- It is more fun, interesting and meaningful to invest in things you care about.
This thinking is at the core of Impact Investing. Asking ‘why’ before designing our investment portfolio means we get to explore what our vision of a better world might look like. What do we care about and want to see more of? From racial and gender equality, to better education, health and food systems, to healing our relationship with the natural world, Beautiful Portfolio Theory starts with identifying the impact we want our portfolio to achieve, then overlays the traditional risk and return requirements that suit our situation. By approaching our investing in this way, we can optimise our portfolio to find the right balance and design a beautiful portfolio that truly represents our needs and values.
I was profoundly moved by an idea I once heard shared by peace activist Satish Kumar, who was asked how we should live our best life. He answered that we should all live like artists, where our lives are the canvas through which we can express ourselves. Imagine that your portfolio could be your investment canvas, the most beautiful version of who you want to be in the world… with your money. Why can’t we be artisan investors?
There is a movement transforming finance and investing from a narrow focus on returns and risk, to a world where investors are as alive and connected to themselves and the world as the artists and artisans we celebrate. Investors who know how to value the things that really matter. Investors who bring love, passion and inspiration into the world of finance. Investors who are building beautiful portfolios. You are welcome.
Danny Almagor is the Executive Chair of Impact Investment Group, and the Managing Director of Small Giants, a company he started with Berry Liberman (who is also his wife) to effect social and environmental change through business, and Australia’s first B Corporation.
To learn more about Beautiful Portfolio Theory, click here or email alicia@smallgiants.com.au.
You can also join Small Giants Academy for its Impact Investing Program: Journey to Impact in Melbourne this October 24th and 25th.