When it comes to investing, sometimes it is better to invest for your own emotional well-being than to be “optimal”.  When people talk about being optimal, it is usually based on math and statistics.

For example, you might have someone who has a large amount of cash that is sitting in the bank and they want to pay off their mortgage with a 4% interest rate.  The so-called “optimal” investor will say that you shouldn’t pay off your mortgage because you can invest the money and make a greater return.

Of course, there is no guarantee that you will make more money investing it.  Bonds and other financial instruments that give you a guaranteed return are the only guarantee.  Even these aren’t technically a guarantee because there is a chance for default, even if miniscule.  But the so-called optimal investor isn’t even talking about investing in bonds a lot of the time.  They want you to put it in stocks, mutual funds, ETFs, etc.

So, they are really saying that you should take on more risk for the chance to earn a greater return.  But the person with cash in the bank who wants to pay off the mortgage obviously isn’t looking for any significant risk.

The optimal investor also usually fails to mention taxes.  When you pay off the mortgage, that rate of 4% is the equivalent of a return on your money in comparison to not paying it off.  But you don’t have to pay any taxes on that 4% equivalent.  If you invest in stocks or bonds and earn a 5% return, then you will have to pay taxes on that money unless it is within some kind of tax shelter like a Roth IRA.

There is a good case to be made if you can get a guaranteed return significantly higher after taxes from the equivalent return of paying off the mortgage.  But again, this isn’t usually what the optimal investor is advocating.

You Aren’t the Casino House

Why are many casinos profitable?  It’s because they play the law of large numbers.  Aside from the money they make from food and lodging, they typically come out ahead with the gambling.  The odds are in their favor with most games.

There will always be winners and losers.  There will be some individuals who leave the casino at night with a lot of extra money in their pocket.  The bet is that there will be enough losers to more than offset the winners.  As long as people aren’t counting cards or rigging machines, then the house is going to win with enough activity.  The odds are in favor of the casino, even if they are slight with each individual game.

If you bet on a coin flip and the other side had a 51% chance of winning because of the weighting of the coin, it is close enough to 50/ 50 that it probably won’t make a difference on one flip.  Even flipping it ten times, there is a decent chance that the 49% side will win more often.  If you flip it thousands of times, then the 51% side has a very high chance of prevailing.

Now let’s bring this back to your personal situation.  Let’s say you are on a game show.  You have just won a million dollars on the game show.  The host tells you that for this final round, you have a choice to make.  You can risk it all.  There is a 90% chance you will win.  You will win $10 million if you win.  So, you have a 90% chance of going home with $10 million (before taxes).

If you risk it all though, there is a 10% chance you will go home with nothing.

For the optimal investor, it makes complete sense to take the risk for the $10 million.  The odds are heavily in your favor.  In fact, it would make sense even if it was to just double your money.

But then we find out that the person is barely scraping by in life.  He makes $50,000 per year and has two kids.  He can barely afford to pay his rent each month.  Does it really make sense to be an “optimal” investor and risk the million dollars for the high chance of $10 million?

I would argue that it doesn’t make sense.  I would argue that the optimal thing is to walk away with the one million dollars, thus guaranteeing a dramatically improved living standard, even if it is to just take the major financial stress out of life.

If you could bet $10,000 and have a 90% chance of walking away with $100,000, maybe it is a different scenario.  Winning $100,000 could really take the edge off of life for someone struggling.

If someone was already worth $10 million and had the opportunity to bet $1 million with a 90% chance to turn it into another $10 million, then perhaps it makes sense to take the bet.  If that person loses out on the million dollars, it won’t be as big of a deal because an extra million wouldn’t have been life changing.

With the original scenario, even someone who already has a net worth of $500,000 might not take the bet. They would rather have the guaranteed one million dollars instead of the good chance of having an extra 10 million dollars.  That guaranteed extra million would make a huge difference in finding financial independence.

Conclusion

You can think up these fun scenarios.  Have this discussion with your family or friends.  What if you could get a guaranteed $1 million or risk it all with a 99% chance that you could double it?  The $1 million might be life changing enough that the 1% chance isn’t worth it.

This is why talking about optimality or efficiency when it comes to investing rarely makes sense.  Maybe it is a variable to know in planning, but your investing has to reflect your own situation, your own personality, and your own goals.

I think people should be asking themselves these questions when it comes to investing heavily in any one thing.  For most people, that is usually stocks.

What if the market crashes and your index funds lose 60% of their value and don’t recover for 15 years?  Are you willing to pay that price (take that risk) for the possible reward of having above-average gains?

There is too much confidence in the U.S. economy and the strategy of buy-and-hold.  The above-average gains in U.S. stocks over the last decade and a half contribute to this overconfidence.  Just a return to the mean will mean losses going forward, at least for a while.

It is good to have a discussion about the scenarios above to determine your risk tolerance.  Your investments should reflect your personality and your goals.