Most of us are prone to systematic errors in our decisions, and I would like to review two of them that seem to come up frequently. (For more, see here and here.)

The first issue is sunk costs. A sunk cost is something that is already spent or some action already taken. The logical error comes when we consider these costs when making decisions about the future. An example may help. Suppose you pay $100 for a ticket to a concert and then lose the ticket. Should you purchase another $100 ticket? Yes. Attending the concert was worth $100 when the original decision was made, and assuming you have $100 more to spend, it should be worth it still. But many people look at the $100 sunk cost (on the first ticket) and phrase the question, “Do I want to spend $200 to go to the concert?” Similarly, if for some reason on the day of the concert you really didn’t want to go (maybe the weather is terrible and you are tired), would you go anyway because of how much the ticket cost? Many people would. However, if they had been given a free ticket (or it was a free concert) they wouldn’t go. We shouldn’t proceed on paths that are no longer optimal because of the consideration of these irrelevant (at this point) costs. Some examples:

• I can’t change careers – I have too much invested in this one.
• We can’t abandon construction on our home – we have too much invested.
• I can’t sell that stock – I paid double what it’s worth now.

It may make sense to stick with your career, house, investments, etc. but the decision should ignore costs to that point. We should look at it as:

• All things considered, will changing careers make me happier than sticking with my current one?
• Will the future value of the home to me be worth more than the estimated future construction costs plus what I could get for selling right now?
• If I had cash instead of the stock, would I pay the current price of the stock to own it?

In short, sunk costs are irrelevant to the decision at hand.

The second issue I want to address is confusing good (bad) decisions with good (bad) outcomes. Not infrequently, poor decisions have good outcomes and poor decisions have good outcomes. For example, suppose someone offers you $100,000 to play a single round of Russian Roulette. If you decide to do so, and pull the trigger on an empty cylinder, you still made a very poor decision even though the outcome was good. Similarly, purchasing appropriate life insurance is a good decision even if you don’t end up dying while the policy is in force. Investing your retirement savings in lottery tickets is a poor decision even if you happen to win. Diversifying a portfolio is the correct decision even if your neighbor didn’t diversify and made a lot of money on a speculative stock.

In short, while it is profoundly counterintuitive, previous investments shouldn’t affect decisions and the quality of the decision is not determined by the outcome!

“Alternative” investments (aka “Alts”) are probably best defined as investments that are anything other than stocks or bonds (and cash is just a bond with a really short duration).

A few years ago I got the CAIA (Chartered Alternative Investment Analyst) designation, and I attend alternatives conferences periodically to be well informed. A recent conference prompts this note.

The attendees at this conference (like all the others) were very enthusiastic about alternative investments, and I was frequently asked about our usage. I usually responded, “I got the CFA to mostly index and the CAIA to own no alternatives at all – it’s a severe level of overkill.” I also sometimes just said we didn’t use them, but I was “alt curious,” which usually got a laugh. Here I thought I would set forth in detail my reasons for avoiding alts.

Though some of my reasons may apply to them as well, in what follows I am not talking about alternatives that have no current or prospective cash flows (other than from selling someday) and are impossible to value mathematically. Proponents will argue with me about that impossibility, but, in my opinion, they are merely grasping for rationalizations to own the investments – particularly since I have never seen anyone do a mathematical analysis on them that concludes they are overvalued.) Those alternative investments are frequently called “collectibles” and would include art, wine, stamps, coins, watches, antiques, beanie babies (at one time), NFTs (more recently), rare cars, trading cards, gold, cryptocurrencies, etc. (That last one, crypto, people would argue isn’t a collectible, but outside of the narrow use of facilitating crime there is no significant current use case for crypto despite a lot of hype. Blockchain, yes. Stablecoins, yes. Bitcoin, et al, no.) Some of those are more ridiculous than others as investments, of course, but all of them share the property that the investment case boils down to, “I think it will go up.” That opinion could, of course, turn out to be right, but it’s vibes-based, not empirical, and since they were first issued in 1997, TIPS are a far better option for protecting wealth against the ravages of inflation.

With those preliminaries aside, let me explain why I am unpersuaded to invest in currently popular alternative investments such as Venture Capital/Private Equity, Private Credit/Debt, and Real Estate (Hedge Funds too, though those are less popular today because the returns have been relatively abysmal for a while).

The trivial (and well-known) reasons are:

1. The fees are very high (compared to traditional investments). Indeed, in economic theory the returns will flow to the scarce factor of production. Supplying capital is not that factor. You would expect (and I do) that more or less all of the excess returns flow to the managers of the funds to the extent they have skill. (You may wonder about the “more” – many, probably most, managers are better at purporting to have skill than they are at having skill. They charge a lot either way.)

2. There is a hassle factor to investing in these. The investment process is onerous. The redemption process is onerous (frequently on purpose). They generally produce K-1s rather than 1099s, and those K-1s are notoriously produced very late – often running up against the extension (not regular) tax deadlines. These things aren’t terrible, but they do tend to annoy the investors. In addition, the work to research and perform due diligence is substantial, which would require us to increase our fees to cover researching and managing them.

3. Alts are illiquid, and more illiquid precisely when you don’t want them to be. This illiquidity is frequently touted as an advantage in the sense that you earn an illiquidity premium, but it isn’t clear why that would be so. Suppose you own shares in a partnership that invests in real estate, for example, that underlying property is illiquid, so it’s purchased at X% off some “true” value. You will also sell at X% off some true value on the back end. Consequently, on the price appreciation there is no advantage whatsoever (though the cash flows from the investment would be higher as a percentage of the amount invested). Even aside from that, it appears that today many investors will happily pay an illiquidity premium because in poor markets they can pretend the value of their investment has not declined when it really has. (Cliff Asness has eloquently made this point here.)

4. The purported low volatility and low correlations with traditional investments are simply not true (or at the very least greatly exaggerated). It’s merely a function of the assets not being appropriately marked to market, which makes the apparent risk and correlations seem low as a matter of pure mathematics. Further, many investors (and advisors) give these factors far too much weight. The return of the proverbial cash stuffed in your mattress has zero volatility and zero correlation with all other investments – but it’s still a terrible investment. (Lottery tickets are also completely uncorrelated to the rest of your portfolio.)

So far, so banal. I think there are four other substantial reasons though:

1. There is extreme positive skewness in the distribution of returns of the investments. This means most of them do poorly, but you are “saved” by the very few that do extremely well. This means you need to own a lot of them, but you would have to be extremely wealthy to afford to do so. This can be partly mitigated with funds-of-funds, but those produce another layer of high fees causing investors to start even further behind.

2. The “good” funds won’t let you in. As Marx (Groucho, not Karl) said, “I refuse to join any club that would have me as a member.” That should be your attitude toward alternative investments unless you are (again) extremely wealthy or a very large institutional investor. The funds with excellent track records are not only closed to new investors, they may also be returning capital to outside investors and converting into family offices for the owners and employees. The capacity of any very lucrative strategy (if you can find one) is very limited. If they need capital from you (or me!) that is a sign that it probably isn’t a great investment. Many remember David Swenson (of the Yale endowment) for his enormous success with alternative investing and writing Pioneering Portfolio Management touting that approach, but fewer realize he subsequently wrote Unconventional Success: A Fundamental Approach to Personal Investment for individual investors telling them not to do that – they aren’t the Yale endowment!

3. You can’t differentiate luck from skill because you will never have a long enough track record. To know whether a portfolio manager who has been beating the market by 2% annually (which is enormous) has skill would require a track record 56 years long. (This is a difference of means test assuming a normal distribution, 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t. With alternative investments it’s even worse. The “uncorrelated” nature of them means the time horizon needed goes up even more. Returning to the earlier example, if the correlation is reduced from 90% to 85%, the time horizon necessary increases from 56 years to 83 years! And keep in mind that many alternatives promise zero correlation (if that were true, the time horizon needed to know with 95% confidence that the alpha is positive, not 2%, simply not a negative number given the other listed parameters, is 543 years). The investment industry, particularly in the alternatives space, is almost entirely faith-based rather than evidence-based.

4. Proponents of alternative investments will tell you to be very careful in what you purchase because one alt is not like the other – even in the same sub-type. (And, of course, their company sponsors the good ones.) With traditional index funds, there are advantages and disadvantages of full replication vs. sampling (though full replication seems better). With alternatives you definitely need full replication, which is impossible because of investment minimums. (It’s impossible for access reasons as well, but I’m focusing on the minimums here.) In academic theory you would start with a market-cap weighting methodology and then deviate from that based on the strength of your belief in the investment. How much belief do these alternative investments require us to have? The market cap of the U.S. stock market right now is roughly $60 trillion. Suppose you are contemplating investing in a real estate limited partnership that owns property worth $60 million. For every $1 million invested in U.S. stocks, how much should you put into the partnership? One dollar. But, of course, the investment has a $100,000 minimum (minimums vary, but that’s typical). So, suppose I have $10 million in U.S. stocks, I should invest $10. But the promoter requires me to be 10,000 times overweight that holding to access it. I’m sorry, I will never have enough confidence to overweight something by that much in my portfolio! Obviously, this is just one example with made-up numbers, but you will always be massively overweight the holding and thus should have confidence approaching certainty that it will have a high return. Arguably, you could also use the Merton share calculation.

TL;DR: Friends don’t let friends buy alts! (IMHO, of course.)

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2025

This month we are going to take a break from our usual technical topics, and discuss a more fundamental issue.  What is the point of all this planning and analysis?  To amass the largest investment portfolio possible?  NO.  It is to reach your highest goals and aspirations.  The problem is that many people don’t have well-defined objectives, and consequently spend their lives vaguely unhappy without knowing why. What is the point of saving and investing if it isn’t FOR anything?

We don’t do extensive “life planning,” but some of the following questions can be very helpful in revealing your deeply held values.

The classic Kinder questions:

1. Imagine you are financially secure, that you have enough money to take care of your needs, now and in the future. How would you live your life?
2. Now imagine that you visit your doctor, who tells you that you have only 5-10 years to live. You won’t ever feel sick, but you will have no notice of the moment of your death. What will you do in the time you have remaining?
3. Finally, imagine that your doctor shocks you with the news that you only have 24 hours to live. What did you miss? Who did you not get to be? What did you not get to do?

Other questions:

1. If you weren’t doing what you are today, and money were no object, what would you be doing (and why)?
2. What expenditures bring you happiness?
3. What’s your definition of “enough”?
4. What do you want your legacy to be?
5. How do you define the term “wealthy”?
6. If you’re wildly financially successful, how much do you want to give to or leave to your kids?
7. Why is your money invested the way it is?

You can have the best portfolio and financial plan possible and still not be making progress toward your deepest desires.  That is what your investments and your financial plan should be about – assisting you in reaching your most important goals.

Steven Covey, in his excellent book Seven Habits for Highly Effective People, uses a simple graphic to categorize activities.  All activities can be categorized as important or unimportant, and urgent or not urgent.

Dwight D. Eisenhower (quoting J. Roscoe Miller) once said in a speech, “The urgent are not important, and the important are never urgent.” Thus, this paradigm has come to be known as the “Eisenhower Matrix.”

Important is self-explanatory, but urgent may not be.  Things that are urgent have some immediacy to them.  For example, going to see a relative who has just been rushed to the hospital or responding to a new social media post.  They both have a quality of immediacy, of something to be done “now”, but the difference obviously is that the first is important while the second is not.  If an activity can be delayed without immediate consequence, it is not urgent.  For example, most people would say getting their finances in order is important, yet they never get around to doing it.  It can be delayed and procrastinated indefinitely – there is no sense of urgency that leads to doing it NOW.

Every activity can be placed in one of the four quadrants as follows:

	Urgent	Not Urgent
Important	I	II
Not Important	III	IV

Mr. Covey makes the point that while everyone does quadrant I activities first (both Important and Urgent), effective (i.e. successful) people do quadrant II activities next (Important yet Not Urgent) while ineffective people spend their time on quadrant III (Not Important yet Urgent).  Everyone generally avoids quadrant IV successfully (Not Urgent and Not Important).

Remember, the key to success is to do more quadrant II activities, by using time and energy freed up by dispensing with quadrant III activities.  Here are some examples of some financial planning activities and where people would typically place them:

Quadrant I (Important and Urgent)

• Preparing tax return before April 15^th deadline
• Going to work every day
• Contributing to IRA(s) before April 15^th
• Signing up for employee benefits before the end of the enrollment period

Quadrant II (Important and Not Urgent)

• Buying insurance (life, disability, etc.)
• Increasing 401k contributions
• Doing estate planning (wills, durable powers of attorney, etc.)
• Implementing a financial plan/investment strategy
• Sending referrals to your friendly neighborhood financial planner (sorry, couldn’t resist)

Quadrant III (Not Important and Urgent)

• Checking what the market is doing today
• Watching talking heads on CNBC
• Attempting to identify (in the words of popular investment blogs, etc.) “Top 10 Stocks to Buy NOW!”