Financial Geekery

The gift of uncertainty

April 7, 2019

There's a reason why Jim Cramer and his big red buttons are so popular. He's flashy and funny and so...certain. You can't lose! He makes things simple, and that appeals to us. Buy "good tape", not "bad tape". Do this, get rich. Do that, go broke.

 

Meanwhile, ask me or my colleagues what we think of Tesla, or the FAANG(M?) stocks, and we'll shrug and talk about the relative efficiency of the market, and the importance of a well-diversified portfolio that matches your risk tolerance and risk capacity

 

"Fine," you'll say. "Forget individual stocks. What about the market as a whole? We just had a yield curve inversion (true as of this writing) -- won't I lose a bunch of money if I don't sell everything right now?" In response, we'll look at boring charts and data on the worldwide correlation between inversions and market returns, and conclude that the data is inconclusive. Then we'll say, with utmost certainty, "Maybe. Maybe not. Hard to say."

 

Maddening, I know. 

 

But this singularly unsatisfying answer has one thing going for it that others don't: it's actually true. The more you dig into investment research, the more you find that, like Socrates, the wise man does not think he knows what he does not know. As Burton Malkiel and other researchers have found, market prices are so noisy as to resemble a "random walk"

 

It's at this point that a lot of people throw up their hands. "There's no knowing what the market will do. I'm at the mercy of Wall Street. There's no point in planning for tomorrow, so I may as well just live for today." This a false and deadly trap. As any statistician will tell you, just because there's randomness in the system doesn't mean we can't make plans around it. Moreover, we can use our "certainty of uncertainty" to our advantage.

 

Monte Carlo and casinos

 

For one thing, if you're facing uncertainty, you're going to need a different set of tools. That Excel spreadsheet that you've used to project your net worth over time? It might be useful in comparing tax strategy A to tax strategy B, but it doesn't mesh with the reality of volatile markets. A Monte Carlo simulation, on the other hand, gives you a sense of how that "random walk" might affect your portfolio's future.

 

Is it perfect? No. But if you engage in adaptive financial planning, you'll increase your chances of catching potential problems before they become major disasters. "Wow, my portfolio's super aggressive, and Monte Carlo shows a lot of scenarios where a downturn at the wrong time will torpedo my plan. Maybe I should dial it back -- I can afford the lower expected returns." 

 

Embracing uncertainty also means thinking differently about financial decisions. When you know everything is a gamble, you treat everything like a bet! Casinos, insurance companies, and the like use this to their advantage: by making a lot of small bets with the odds tilted their favor, they're able to make a ton of money overall. They don't make bets they can't afford to lose; they do make bets that others can't afford to lose; they're systematic in their bets; they make as many (good) bets as possible. The more you think like a casino, the more you can tilt the odds in your favor.

 

Research-based investing

 

If the market is uncertain, then that's going to radically change how you put together your portfolio. Certainty means finding that "good tape and bad tape", timing the market, and otherwise pretending that you can see the future. Uncertainty means building assumptions of volatility into your investments, and using statistical research to build your portfolio. 

 

First and foremost, this means being brutally honest about your risk tolerance. If there are going to be unavoidable downturns, how much can you lose in the short term without losing sleep? If you don't believe you (or your investment manager) can catch the upturns while avoiding the downturns, how much of the ups are you willing to forego in order to avoid the worst of the downs? 

 

It also means engaging in incremental strategies that increase your chances of higher returns net of risk. Strategies such as efficient portfolio designmulti-factor tilts, opportunistic rebalancing, and tax-loss harvesting all assume volatility and semi-randomness in the market. In fact, they rely on it -- without volatility, literally none of the strategies mentioned above would make sense!

 

Note that I said "increase your chances", though -- there have been and will be periods of time when these strategies don't play out! Like the casino, you won't always win in the short term.

 

Plan B

 

If you're truly embracing uncertainty, you have to recognize a hard truth: even if every bet is in your favor, you may still "lose". If your Monte Carlo simulation shows a 99% success rate, that still means that 1% of your scenarios fail. You still have to contend with the possibility of a perfect storm that comes out of nowhere and disrupts your financial plan. (To hammer this point home, many Monte Carlo simulators won't show a 100% success rate, even if every single simulation passes!)

 

This uncertainty underscores the importance of Plan B. What if my 529 tanks right before my child enters college? Your Plan B might be to take out more student loans, or fund more of college from other sources like your brokerage or IRA. What if there's a market downturn right before I retire? Your Plan B might be reducing expenses, delaying retirement, downsizing your home, or taking on a reverse mortgage. 

 

Plan B serves two purposes. For one, it helps you avoid sleepless nights: for some people, a well-thought-out Plan B is the difference between anxiety and peace of mind. Let's say you're a financial nerd who's reading this blog and confident of your ability to handle whatever comes, without need for a concrete Plan B. Great! But let's also say you have a partner who's not a financial nerd and expresses worry and anxiety over the uncertain future. Chances are that they won't be satisfied by vague reassurances that "it'll all be OK" or "I can figure that out if it happens". A specific Plan B, though, is a different story: "if X happens, we can do Y, which will have outcome Z" -- even if Z is suboptimal! -- can do emotional wonders.

 

Creating a Plan B also has a practical purpose: it forces you to actually figure out what you might do, and take steps now to prepare. How will you know when to execute Plan B? (Will it be a certain Monte Carlo success rate, or a certain portfolio value?) Which expenses would you reduce? Which student loans would you apply to -- and what should you be doing now (e.g. filling out the FAFSA) to prepare? The better you prepare for Plan B, the more likely you are to execute it successfully, and with less stress.

 

Want some examples? Plan B is worth a whole article unto itself!

 

Placing a premium on flexibility

 

Of course, uncertainty also means that there are more things in heaven and earth than are dreamt of in your Monte Carlo simulation. What if you're offered the perfect job -- but it requires a pay cut, and/or relocation? What if your (carefully planned) child turns out to be twins? What if you get divorced and have to pay for a lawyer? What if, in short, life happens?

 

And make no mistake, life will happen! Moreover, per the "end of history illusion", chances are high that we'll underestimate just how much our lives will change. Which means that even as we run our projections and create our Plan B's and make our bets, we'd be smart to place a premium on flexibility.

 

What does "placing a premium on flexibility" look like? Well, for one, you're probably sick of hearing financial planners recommend that you should have (say it with me!) "3-6 months of basic expenses in emergency savings". But placing a premium on flexibility literally means paying for it -- for example, having money sitting in a safe, accessible, relatively-low-earning account, Just In Case.

 

Flexibility might also look like targeting your nondiscretionary expenses to be less than 50% of your total income after taxes. Sure, you could take on more debt that might pan out in the long run -- or you could place a premium on flexibility, keeping your cash flow in a position where you can better take on opportunities and handle threats as they arise. (Dave Ramsey's whole debt-free movement was inspired by his first-hand experience in this area!)

 

Or it might look like keeping more of your investments in liquid assets, like ETF's, traded REIT's, mutual funds, and other such securities, and less of them in hard-to-trade assets like physical real estate, private equity, and gold coins

 

Or it might look like renting instead of buying, and so on, and so forth. You get the idea. 

 

Embrace uncertainty - now!

 

"Always in motion in the future", quoth Yoda, and I've yet to meet anyone that argues otherwise. But it's another thing entirely to embrace this truth wholeheartedly and fit it into your financial life. Hopefully, I've given you some practical ideas on how to go about doing this.

 

I'm not letting you off the hook just yet, though. Pick one of those ideas -- just one -- and get started. Sit down for 15 minutes and create the outline of a Plan B, or do some reading on research-based portfolio design. If you've read this whole article, you might have the time right now; if not, put it in your calendar. It's 15 minutes -- you make that happen! At the end of those 15 minutes, figure out the next step and plan out another time chunk to take that step. I'm willing to bet that with just a little bit of time invested in embracing uncertainty, you can greatly improve your financial plan.

 

And if you'd like some encouragement and/or guidance: post a comment! I'm happy to geek out on whatever it is you're looking to do!

 

Of that, you can be certain.

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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