The primary risk you face as an investor probably isn’t what you think. The largest risk is the uncertainty about your lifetime consumption. How much money you’ll need for the remainder of your life trumps every other risk. The amount of money you’ll need is always uncertain because you don’t know how much you will spend or how long the money needs to last.
How do you make peace with uncertainty?
Professor Ken French says, “My goal is a portfolio I can justify to myself today, based on the information available now.” It’s impossible to know what unexpected events will happen in the future. You only know what your circumstances are now and what the world around you looks like today. Don’t judge your future outcomes based on what you might know in the future. Assess the results by what you knew at the time the decisions were made.
When you’re uncertain, you become fearful of what might or might not happen. Trying to make informed and rational decisions when you’re fearful is difficult.
It’s important that you distinguish between things that are uncertain and things that are unknown. Uncertainty is an inherent component of both natural and man made systems. You can’t control uncertainty. The weather is uncertain; the financial markets are uncertain.
Something that is unknown differs from commonplace uncertainty. A plane flying into the World Trade Center is an example of something unknown. That’s a ‘black swan’ event and can’t be predicted. Donald Rumsfeld coined the phrase many years ago that there are always “unknown unknowns.”
You can start to defuse uncertainty by thinking about your portfolio holistically instead of as individual pieces. Your overall portfolio, combined with your other sources of wealth, is what actually matters.
The process of making peace with uncertainty involves planning for a wide range of possible outcomes. Yes, it’s comforting to know that over the past century or so, stocks have performed very well. But you can’t plan on that for the shorter-term. Very few calendar years have produced stock market returns close to the long-term average. Most of the time, returns are much higher, much lower, or somewhere in-between.
Understanding the wide variance with short-term investment returns is a big step toward making peace with uncertainty. If you’re saving to buy a house or pay for college education expenses, you should treat those potential future expenditures as a liability. You need the funds available to pay for those liabilities at a certain time and this should drive your investment decision-making.
Financial markets, the economy, and inflation are all uncertain during the short-term. The best way you can deal with this uncertainty is to prepare for some surprises. Your life usually doesn’t follow a straight path. There usually will be many twists and turns along the way.
It can be difficult to make peace with uncertainty, but when you do, your decision-making framework becomes much clearer.