August 27, 2019

Thinking in Probabilities…

Carroll Financial Summer 2019 Quarterly Newsletter

Summer 2019 Quarterly Newsletter

Author: Larry W. Carroll, CFP®

Estimated Read Time: 3 minutes

 

We live in an uncertain, risky world and as investors we invest with uncertainty as well. Markets move up and down and we are never certain of the outcome, yet we long for certainty and for precision. We want the comfort of knowing 100% how things will turn out. Unfortunately, deep down we know that isn’t the case. After the recent run up in stocks, investors started to expect high returns. We call this recency bias, which is the tendency to believe that the most recent outcome is the most likely outcome. We know the good times won’t last and we know markets go up and down, but we don’t always act on that knowledge.

I want my clients to embrace uncertainty and be extremely skeptical of anyone’s forecasts (yes, even mine). Before you believe that email predicting the impending collapse of the Federal Reserve, ask yourself: What is the track record of the person making this prediction? Is there some unique information that this person has that the rest of the market has not accounted for? Do you really want to change your portfolio and disrupt your long-term plan based on this prediction?

Let’s say that there is a 10% chance that at some point during your retirement there will be a 60-80% decline in stock prices. How does that feel? How would you deal with that? Would your plan survive that kind of correction? Notice that I did not predict that correction. In fact, I said that 90% of the time, you would never experience it. Yet the idea of that uncertainly is powerful. I am not trying to worry you, but I am saying that there may be a good reason to reduce risk.

William Bernstein said, “When you’ve won the game, stop playing.” That doesn’t mean that once you have enough money to fund retirement, you should take the cash and bury it in the back yard. It does mean that you need to talk with your advisor about how much risk is really appropriate, especially as the game changes during retirement. It is not all about getting rich. It is about never being poor.

Determining risk in a portfolio can be a challenge. Investors tend to underestimate negative probabilities and their consequences, particularly after the long bull market we have witnessed since 2009. We are all emotional beings, we all have biases that we develop over the years and we will all make our share of mistakes. Controlling risk should mean that none of those mistakes lead to consequences we cannot accept.

Trying to measure risk tolerance is a difficult job. I have never been a big believer that any questionnaire could assess a person’s true risk profile. It is our obligation as advisors to point out the probabilities and to react quickly when circumstances change… and hopefully to tell you when to stop playing.

 

This article was featured in our Summer 2019 Quarterly Newsletter available here: 

 

Required Disclosures: The views are those of Larry Carroll and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation to its completeness or accuracy. All economic or performance data is historical and not indicative of future results. Investors cannot invest directly in an index. 

Market Update, Risk

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