You Put Salt In Cookies?

Just like baking, there is a science to investing.

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Some time ago I was helping my wife make cookies. Everything was going well until she began looking for the salt. I had to question this. “Why are you putting salt in cookie dough? There is nothing salty about cookies.” She explained that almost every cookie recipe calls for a little bit of salt. It has something to do with bringing out the other flavors. I really can’t recall the full explanation because the world, as I knew it, had just been changed forever.

As it turns out, behavioral economists refer to my bias against salt in cookies as “narrow framing.” Rather than looking at all of the ingredients and how they work together to create a finished product, I was evaluating each ingredient independently.

Just like baking, there is a science to investing. One of the most well-regarded investment theories used by professional investors is called Modern Portfolio Theory. The basic idea of this theory is that by combining investment assets that behave differently from one another, the overall risk of the portfolio is reduced. Investors who follow this theory design portfolios that are intended to have pieces that will not perform as well as others at certain times. This is all based on the idea that no one knows when certain investments will perform better than others.

Narrow framing does not work well with a well-diversified portfolio built for the long haul. At any given time, one asset class will be underperforming the others. If you evaluate this part of your portfolio independently, but only in relation to your better performing investments, there will be a temptation to abandon the long-term strategy. Common examples of this behavior include adding more to the latest hot investment (like gold) and eliminating asset classes that haven’t performed as well in the recent short term. This is really no different than eliminating salt from a cookie recipe because cookies aren’t salty.

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