Investment Paradoxes Challenge Our Thinking

Summary: Ancient philosophers invented paradoxes as puzzles to sharpen their wits. Can a contradictory statement be true and false simultaneously? Click through to see how seemingly illogical situations can lead to investing success.

Investing and finance reveal some paradoxes that make obvious-seeming truths appear impossible. A glance at some relevant cases shows how economics and financial markets also move in mysterious ways. Investors who ponder these riddles may refine their approach to the subtleties of money and capital markets.

Lessons from philosophers

Paradoxes can teach some principles for what to do and what to avoid. Finance is somewhat like chaos theory: although an underlying logic prevails, often the forces are so hard to observe that they appear almost random.

Question: Why do we not improve our portfolio performance by working harder? Answer: Correlations between effort and outcome are not linear. Results derive from not only effort, but a unique perspective, discipline, analysis and informational advantages.

Question: Why does taking extra risk require higher returns? Answer: As stocks (or other assets) rise, we may pay prices over intrinsic value, which creates riskier investments.

Question: If – big if – markets are efficient, why buy anything except an index? Answer: Maybe you should stick with an index!

Thus, there are indeed some answers, but solutions frequently elude us.

Some economic enigmas

The following problems have teased great economic thinkers. Some have been solved, or at least suggested plausible hypotheses.

• How can asset prices seem overvalued, extending far from intrinsic value, and yet markets continue to propel them upward to new highs? Many expensive winners of the past 140 years kept soaring. Sometimes investors just need to buy high and sell higher.
• Some of the greatest fortunes are made from owning just one stock. (Think Microsoft.) What happened to diversification?
• One of the most frightening fears is to outlive one’s savings. Yet relatively few investors buy single-premium immediate annuities, which are possibly the simplest solution.
• Economist Hyman Minsky argued that the longer stable economic and financial conditions persist, the more drastic and damaging the aftermath when a crisis eventually strikes. In other words, stability harbors the seeds of its destruction.
• Every analyst or investor relies on historical averages. Yet each of us has only one investing life to live, so we never individually experience the average itself.
• The great Maynard Keynes wrestled in the 1930s with the paradox of thrift. He observed that the public’s personal savings can hurt more than they help during a recession. (Earlier economists had argued that prices should clear and producers should adjust to weaker conditions.) Contrary to common wisdom, Keynes called for lower interest rates to lower savings and boost spending, to promote growth. The paradox is that what makes sense for households may not apply to the overall economy.
• The equity premium puzzle highlights the excessive outperformance of stocks over T-bills. The 5%-8% equity premium theoretically reflects compensation for the higher risk of stocks, compared to treasuries. Yet that level indicates an unreasonably high degree of risk aversion.  Why? Are some investors neglecting the contribution of dividends?
• The St Petersburg paradox asks why people are willing to play games of chance if they have only a 50/50 probability of winning. After several rounds, they may be less inclined to participate. Perhaps the marginal utility of their gains decreases as they amass a pile of winnings.
• Why are useless diamonds more expensive than essential water? Again, marginal utility provides an answer. Adam Smith noted that the choice is not between all diamonds and all water, but one additional diamond versus one more unit of water.

Stay humble

Having more information boosts confidence, but also impedes the ability to make financial or other decisions.

The more you know, the more you realize how much you are missing. In many matters, simplicity works best, although complexity may feel smarter and more alluring.

Perhaps the Greek philosopher Socrates had the final word as he pondered the paradoxes of the world: “The more I know, the more I realize that I know practically nothing,” the ancient sage concluded.

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