moneyFYI
Financial Freedom Is Merely Organized Common Sense
How Does Risk Affect You?
It is a near-sacred assumption in the theoretical study of financial assets that people will only accept more risk if they get a reward for doing so. That’s an assumption based on the history of the stock and bond markets. It seems convincing, yet it is not necessarily true in your unique circumstance.
Persuasive and necessarily factual for all conditions are not the same thing. People should pay attention to that.
Why should I not accept the premise fully?
The Historian’s Fallacy
There is the informal logic flaw called “The Historian’s Fallacy.” People assume the decision-maker knew the same things that people know now. We can all agree that that assumption is absurd. You cannot decide based on what will happen in the future. Decision-makers understand what they know at the time and no more.
Nine years ago, I wrote an article titled, “Are You Smart Enough To Know The Future?” It dealt with decision-making, particularly Ron Wayne’s decision to sell his 10% interest in Apple Inc for less than $2,500. I argued it was a good decision given his position at the time. Given what happened since, you could say it was less than excellent—the Historian Fallacy in action.
Ron Wayne did not know the future and therefore could not act upon it. We see the past and can easily say it was a weak decision.
You will live in the future, not the past.
You use the past to help you make decisions, but you know only some of the past, and what you know may not be helpful to you. Part may not be right at all. Consider what you know because of what “Experts” have told you. That’s “Argument from Authority.” Experts sometimes err, and you should be aware of that.
The future is unknowable
Your reality is that you do not know and cannot reliably predict the future. The future is the risk, not the investment.
The problem gets worse as we dig deeper.
- Market risk, based on historical details, can be known. We don’t know whether or not the future will bear any resemblance to the past. It’s like mathematical linear regression analysis. No one can reliably estimate events outside the observed data.
- Events that did not happen are unrecorded. Absence of evidence is not evidence of absence. In physics, Erwin Schrodinger has postulated that unless an event is specifically prohibited, it will eventually occur. You cannot make a list of all that has not yet happened or even that which did happen. The future will contain things that appear obvious after they happen.
- History ignores some essential information. Stock market data has a profound survivor basis. Some vital information is certainly missing because it didn’t seem important.
- What happened does not be what could have happened and maybe was more probable. What happened is not a more reliable fact than other things that could have.
- Mathematically, risk is a function of two factors. The factors are 1) probability of the outcome and 2) the magnitude of the gain or loss. Personal risk is not the same thing. If you take the mathematical risk and add in the effects on you, if the risk appears, all sorts of different answers occur. Ask three questions, 1) How bad can things be before I cannot tolerate the outcome?, Is that level of loss possible? And 3) Should I participate in any risk situation unless you can accept the adverse result?
Consider your capacity limit. No individual has personal risk equal to average risk in the market over a long time. Could be more or less. That’s simple to understand. It does not matter what long-run risk is if you don’t survive the short run.
Never rely on averages. If the average depth of water in a river is four feet, you should not assume you can wade across it without drowning. The same thing holds true for average returns in the stock market. As Keynes postulates, “the market can stay crazy longer than you can stay solvent.”
The bits to take away.
History is the record of what the historian thought to be relevant. It is perceived only in that context. Perspective matters, From Aesop, “Until lions have their historians, tales of the hunt shall always glorify the hunters.”
Mistrust average
Understand your risk profile. It contains three factors
- Exposure, – You control exposure.
- Tolerance, – Tolerance is mostly emotional and is hard to deal with rationally after the fact.
- Capacity, – You can decide in advance whether a situation is possibly capable of producing results you could not survive. Avoid those unless you can manage it as it unfolds.
Stay curious about what is happening and periodically update what the past means for you.
Learn to make decisions with incomplete and/or conflicting information
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I build strategy and fact-based estate and income plans. The plans identify alternate ways and alternate timing to achieve both spending and estate distribution goals. In the past I have been a planner with a large insurance, employee benefits, and investment agency, 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. I have appeared on more than 100 television shows on financial planning, have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, Banks – from CIBC to the Business Development Bank.
Be in touch at 705-927-4770 or by email to don@moneyfyi.com
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