I’ve written about a number of concepts that can improve the robustness of an investment strategy. For most people, the investment strategy fits within a larger financial plan. It is probably the largest portion of the plan, especially for a goal of financial independence. However, a plan should be also be robust to risk in order to achieve all goals.
The idea is to plan using negative scenarios. Most people are optimistic and, as such, plan using the assumption that everything will work. This, combined with the fact that not everyone plans ahead, probably explains why only 1 in 10 new businesses survive past five years. People tends to assume that nothing will go wrong, they take too much risk and they are unprepared to deal with the consequences. It’s fun to imagine how great things will be if everything works out, but it’s pragmatic to be prepared for things to go wrong.
What are all the things that can go wrong? Each assumption must be modified to account for a worst-case scenario. This doesn’t mean that everything could go wrong at once. But each risk must be realistically assessed. Then, an appropriate response needs to be prepared. There are three alternatives when faced with risk: 1. accept it, 2. reduce it or 3. insure it. I will offer some examples.
The memory of the market crash in 2008 still feels fresh, even though it happened over two years ago. Many people questioned why their advisors didn’t warn them that the market could crash, and get them out. We know that markets crash every so often. As an advisor, this is a risk that I had chosen to accept. For one thing, there’s no way to prevent it and it’s difficult to avoid participating in it, without causing greater damage. As an aside, clients were not so sanguine; they never felt that they had accepted that risk.
Many investors (who accept modern portfolio theory) equate volatility with risk. They don’t like it when their investments fluctuate. Because they don’t accept the risk of volatility, they choose to reduce it. They invest in asset classes that have a low correlation (one zigs when the other zags) and reduce the fluctuations along the path.
Many people won’t accept the risk that they could be disabled or die while they are responsible to support their family. Because this is a risk that they don’t accept, but cannot reduce (short of retiring), they buy insurance. Insurance is intended to cover a catastrophic loss. In the case of an insured loss (life, for example), the insurance company will issue a cheque that will offset the loss, effectively negating the risk.
My fear is that many people accept risks they don’t understand. What is the chance of dying in a car accident on the highway? Honestly, I don’t know. That doesn’t mean I would choose not to wear a seat belt, just because I think I’m unlikely to need it. If I crash, a seatbelt could be the difference between life and death. Because I’m not willing to accept the negative consequence of this worst case scenario, I wear a seatbelt whether I need to or not.
This kind of thinking isn’t fun, because it requires looking at the worst that could happen. What if the companies I have invested in cut their dividends, will I have enough income? What if the market crashes and the capital growth is negative one year, does that impact my ability to make lump sum withdrawal? What if I can no longer work and earn income or save for the future?
My preference is to be prepared for any scenario. Because I don’t know what will happen with interest rates or my ability to earn income, I prefer to avoid debt. Because I don’t whether or not I will become disabled or die while I’m working, I prefer to work toward early retirement. Because I don’t know when the market may crash again, I prefer to achieve investment income from dividends instead of realising capital gains. We only get one life when playing this game, and I want to make sure that I don’t lose the game part way through.