There Is More To Losing Than The Probability of Loss

I have been reading Thomas Friedman’s book, “Thank You For Being Late.” and recently had an opportunity to see what he means by the idea. I was required to wait for an appointment for 45 minutes.  Fortunately my Kindle copy of Andy Martin’s excellent book “Dollarlogic” was available.

I chanced to reread an early part of the discussion about risk.  I think everyone has an intuitive idea of risk, but Andy keeps it in perspective.  The idea is not whether there is a risk that the stock market may fluctuate but is there a risk that your chosen investment method may not meet its purpose? When you look at the goal, the risk of short fluctuations may not be important.

He points out that if you put all your money in certificates of deposit, you may have less volatility but run the risk of having too little money when you need it in the future. That risk matters.  The same thing happens if you store your money in a tin can buried in the yard. The question is one of addressing the purpose and the methods of achieving the goal.

If your purpose is to have retirement money 30 years hence, do fluctuations next month matter?

Answer is “No they do not,” but our psyche makes them real.

Here is another way to think about it.  We need a little different idea of how volatility and risk are tied together.

Suppose I tell you that because of market volatility there is a one chance in five probability of the market falling 10% in the next 30 days and a four chances in five of it rising 0.5%. A mathematically neutral situation if it comes up frequently.

Should you do anything? If you sell and avoid the one in five odds of a loss, you miss the gain four times more often. Worse,  the market might fall more or less if it falls at all, or it might rise even more. The probabilities look concrete but they are actually fluffy. And that is not the end of the problem.

Suppose I said there is a one in five chance of losing 10% in the next 30 days but there is 0% chance that you will sell if it happens. Do you have a loss? Rationally no, but emotionally yes. Joint probabilities always give you that sort of answer.

To have a real effect,  several things must all happen.  There must be volatility.  The volatility must be negative in the short run, and you must crystallize the loss.  Most people forget that if they do not need the money at the end of the month,  then the loss does not exist. A probabilistic loss could happen but unless the “no chance of cashing in” is wrong,  the loss will go away as the fluctuations even out.

People never consider the 0% probability of cashing their entire retirement fund on a day 29 years before they need it and instead worry about the insignificant fluctuation.

Joint probabilities are the product of the individual probabilities. Multiply anything by zero you get zero as the answer. If you won’t be selling, it does not matter.  Pity we are emotional.

Market fluctuations are like static on AM radio. The underlying signal remains and the static distorts your ability to hear it. You will not get much information by paying attention only to the static. Focus on the signal and what your end point must be.

Lower but more predictable yields have a far bigger negative effect on your wealth than variations.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.