Understanding Expected Utility and Its Relation to Utility

If the wealthiest families of the past century spent a reasonable amount of their wealth, invested in the stock market, and paid taxes, there would be thousands of billionaires today. But there aren’t. So, what happened? To answer this question, we are joined by authors and finance professionals, Victor Haghani and James White. Their recently released book, The Missing Billionaires: A Guide to Better Financial Decisions, uses the missing billionaires puzzle to explore how and why most investors fail to capture the returns offered by the market. Victor was a founding partner of Long-Term Capital Management (LTCM), the multi-billion-dollar hedge fund that famously collapsed in 1998 and nearly took the global financial markets down with it. His participation in the downfall of LTCM led him to reassess much of the way he thought about investing, and in this episode, he shares some simple but powerful frameworks and personal finance recommendations. We also receive accessible explanations of the Merton model and expected utility theory from James, take a deep dive into dynamic asset allocation, discuss optimal solutions for lifetime spending, and learn more about the certainty equivalent return and Sharpe ratios, plus so much more. Whether you’re an entrepreneur invested in your own business or simply focused on building long-term wealth, Victor and James’ book (and this conversation about it) will be a valuable resource for better financial decision-making, so be sure to tune in today!

 

Key Points From This Episode:

 

• (0:05:19) The puzzle of the missing billionaires (and why it matters to Victor and James). 

• (0:09:45) Some common but critical financial decision-making problems most people face. 

• (0:12:39) Unpacking the coin-flipping experiment in their ‘What's Past is Not Prologue’ paper. 

• (0:19:57) What investors should aim to maximize when sizing positions in risky assets. 

• (0:24:22) An example that illustrates how the Merton model relates to bullish bets. 

• (0:29:04) What the Merton share tells us about dynamic asset allocation if it is or isn't possible to estimate expected equity returns. 

• (0:35:29) How real expected returns affect optimal risky shares for long-term investors. 

• (0:37:29) Different ways to forecast volatility to determine the optimal risky share. 

• (0:42:00) Easy-to-understand definitions of the utility curve and expected utility theory. 

• (0:50:20) Using the certainty equivalent return and Sharpe ratio to evaluate investments. 

• (0:57:56) Whether or not options belong in the portfolios of typical retail investors. 

•  (0:59:01) If expected utility is a good model for normative personal finance recommendations.

• (1:05:16) How Victor’s experience with LTCM affected him, both professionally and personally. 

• (1:09:08) What optimal solutions for lifetime investing and spending look like. 

•  (1:22:22) Questions to ask yourself to work out your own utility function and risk aversion.

• (1:28:19) Victor and James’ parting financial advice and respective definitions of success. 

Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-270-what-happened-to-all-the-billionaires-with-victor-haghani-and-james-white/25122

Books From Today’s Episode:

The Missing Billionaires – https://www.amazon.com/Missing-Billionaires/dp/1119747910

Stumbling on Happiness — https://www.amazon.com/Stumbling-Happiness-Daniel-Gilbert/dp/1400077427

The Man Who Solved the Market – https://www.amazon.com/Man-Who-Solved-Market-Revolution/dp/B07P1NNTSD

Links From Today’s Episode:

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

Shop Merch — https://shop.rationalreminder.ca/

Join the Community — https://community.rationalreminder.ca/

Follow us on X — https://twitter.com/RationalRemind

Follow us on Instagram — @rationalreminder

Benjamin on X — https://twitter.com/benjaminwfelix

Cameron on X — https://twitter.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Victor Haghani on LinkedIn — https://www.linkedin.com/in/victorhaghani/

James White on LinkedIn — https://www.linkedin.com/in/james-white-b4310a47/

Elm Wealth — https://elmwealth.com/

When Genius Failed — https://www.amazon.com/When-Genius-Failed/dp/0375758259/

Where are all the Billionaires?: Victor Haghani at TEDxSPS – https://youtu.be/1yJWABvUXiU

‘What's Past is Not Prologue’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3034686

‘Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case’ – https://www.jstor.org/stable/1926560

‘Stock Prices, Earnings, and Expected Dividends’ – https://www.jstor.org/stable/2328190

‘No Place to Hide: Investing in a World With No Risk-Free Asset’ – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3903372

‘Sharpening Sharpe Ratios’ – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=325942

‘A Sharper Lens for Sizing Up Nickels and Steamrollers’ – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874602

‘Do Options Belong in the Portfolios of Individual Investors?’ – https://elmwealth.com/do-options-belong-in-portfolios/