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 statistical analyses such as the Sharpe ratio and the Treynor ratio, measuring risk-adjusted returns.
Bored yet? Maybe it’s just me, but I’m 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 risk. Through a statistical analysis of the past, one might calculate the risk of a particular weather event, say a flood, or bushfire, to be a one-in-100-year event. We now know that the past is no longer a good predictor of the future, and, thanks to global warming, those same one-in-100-year events are now happening almost annually. Even when we can calculate the risks reasonably accurately, the folly of our minds means that many people fear a terrorist attack more than they fear a heart attack.
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 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?’.
Kate Raworth describes the ‘why’ in her simple and brilliant model of Doughnut Economics. The purpose of our economy is to create the good society, one that protects the planetary systems that support life including clean air, water, soil, biodiversity, a healthy atmosphere, the ozone layer, etc., while nourishing all humankind with food, shelter, freedom, belonging, healthcare, education and more. Kate’s model sets the social foundations on the inside of the doughnut and the ecological boundaries on the outside. This reframing of our economy, as the safe and just space between these two boundaries, helps us to redesign the role of capital and investing into a more wholesome and beautiful exercise. The purpose of our economy is simple: to support human flourishing and wellbeing, while preserving and protecting the ecological systems that all life on Earth rely on.
Instead of the Modern Portfolio Theory, let’s celebrate the Beautiful Portfolio Theory. The Beautiful Portfolio Theory 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. Every investment should be asking whether it is healing or harming the ecology.
- 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). We are starting to see this in escalating distrust of institutions and the increasing fragility of democracies around the world.
- It is more fun, interesting and meaningful to invest in things you care about.
This thinking is at the core of Impact Investing. The first question we must ask before designing our investment portfolio, and before any single investment, is whether our investments are contributing to our ‘why’. To answer that question requires an exploration of what our vision of a better world might look like – our Good Society. What do we care about and want to see more of? Maybe it is gender equality, or better education for our children. Maybe it is a more humane and sustainable food system, or better healthcare. Maybe it is resilience to natural disasters, or elevating the consciousness of humanity. Or maybe it is all of them, taking a systems approach to your strategy.
Beautiful Portfolio Theory starts with identifying the impact we want our portfolio to achieve, and 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 that is 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.
