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Squatting, a basic form of human movement is used to sit down, stand up, and move large objects. In the fitness industry, it’s a fundamental lift to build full body strength and increase athletic performance. As simple as the movement seems, there are a lot of nuances to making the squat “optimal,” with a quick Google search leading to a plethora of tips and tricks. The author of The Squat Bible, Dr. Aaron Horschig, recommends the following:
1. Toe angle slightly outward
2. Foot stability (tri-pod foot pressure)
3. External rotation torque
4. Hinging at the hips
5. Postural integrity
In Horschig’s opinion, following these principles will lead to a more efficient squat technique, allowing for greater loadbearing and reduced risk of injury.
On its surface, building efficient portfolios also seems to be quite simple, with most pointing to modern portfolio theory (MPT) as the foundational paradigm. Introduced by Harry Markowitz in the 1950s, MPT lays out a mathematical framework for achieving the “optimal” portfolio. Intuitively, the main pillar of MPT assumes that individuals prefer less risk to achieve higher returns. It prescribes the following steps:
1. Identify assets to include in a portfolio;
2. Determine the expected return (mean) and variance of each asset;
3. Determine the correlations between each of the assets;
4. Develop an efficient frontier, plotting the portfolio asset weights against expected return and standard deviation;
5. Draw a capital allocation line from the risk-free rate tangent to the highest Sharpe portfolio along the efficient frontier; and
6. Overlay the client’s indifference curves (mean and variance) to find the “optimal” portfolio.
According to MPT, following those steps leads to the optimal portfolio for the individual’s risk and return preferences.
But knowing how to build the optimal portfolio is not enough.
As anyone going to the gym for the first time can attest, knowing the foundations of a perfect squat is also not enough. To reduce the risk of injury, strength and physiology must be considered. Individuals have differing mobility ranges and bone structures that can prevent the execution of the “optimal” squat. For example, many strength coaches look for a posterior pelvic tilt at the bottom of the squat when working with novice athletes. The butt wink, as it is known, is a curvature in the lower back caused by limitations in the hip socket and/or ankle mobility. This can put the spine in a compromised position while also reducing core stability, leading to a loss of power and an increased chance of injury. While one can work on their ankle mobility, it is near impossible to change your hip socket.
In much the same way, just understanding the procedures to building the “optimal” portfolio doesn’t guarantee success. In this instance, the limiting factor is not physiological but psychological–behavioral biases. While there are many biases that can limit the construction of the optimal portfolio, one that is often discussed is loss aversion. First recognized by Nobel Laurette Daniel Kahneman and his colleague Amos Tversky, loss aversion is the emotional impact of losses versus gains. In general, Kahneman and Tversky recognized that individuals experienced more pain in losses than pleasure in gains. For example, assume you were offered a bet: heads you lose $100, tails you win $150. Would you take this bet? Even though the expected outcome is $25, they found that most individuals would not accept it. The pain of losing $100 weighed more than the possible pleasure of gaining $150. This departure from the “rational” human should be accounted for in the portfolio-construction process.
Squatting programs are designed to make individuals stronger and healthier. The theoretical foundations help accomplish this by allowing an individual to increase load over time while also reducing the risk of injury. Injury will derail the training program and/or dis-incentivize further progression. Therefore, a trainer should diagnose physical variabilities before recommending any program. If there are physical limitations, they can be addressed and/or adapted. In the case of ankle mobility (limited flexion in the ankle), there are certain stretches and movements to increase the range of motion. With a hip socket limitation (physiological), the trainer can adjust your stance, toe angle, load, and/or other deviations to safely perform the squat.
With portfolio construction, we are trying to achieve a stated financial goal, e.g., growth or income. Markowitz formalized this process with MPT, correlating risk and return. However, MPT assumes individuals weigh losses and gains with the same emotional proportionality, using standard deviation as the key driver to risk assessment. But this is usually not the case. In fact, individuals assign1 losses 1.5 to 2.5 times that of gains. With this insight, a financial practitioner should diagnose an investor’s loss aversion before implementing any portfolio. If done incorrectly, or not at all, then the investor is bound by their innate emotional reactions during times of stress (losses). This will inevitably lead them to abandon the “optimal” portfolio at the most inopportune time, in essence derailing their investment success.
Much has been learned about investor behavior since the introduction of MPT. Following its prescriptive process is no longer enough because behavioral biases, much like physiology, are an immutable condition. Not assessing range of motion and/or physical differences for the squat will lead to injuries. In the case of portfolio construction, not properly diagnosing the individual’s pain points will lead to an unadhered portfolio. In both instances, it is not the foundational principles that failed, but limitations to human physiology and psychology. Individualized variabilities should, and must, be properly diagnosed to increase the probability of portfolio success.
Even the father of behavioral finance, Kahneman, recognizes this. When asked what can be done to overcome biases, he replied, “Very little; I have 40 years of experience with this, and I still commit these errors.”
Krisna Patel, CFA, is an Investment Advisor Representative of Woodbury Financial Services, Inc., at 11001 W. 120th Ave. Suite 400, Broomfield, CO 80021. Krisna may be reached by phone at (317) 489-3505 or by email at [email protected]
1Kahneman, Daniel. Thinking Fast and Slow. Farrar, Straus and Giroux. 2011
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
