Over the past couple of years, we have explored several themes that challenge core tenets upon which modern finance and portfolio theory have been built. Perhaps the most significant of these tenets is the subtle, but significant, difference between risk and uncertainty—and the resulting impact on markets.
This exploration of ideas has led us to a new approach that we are excited to share with you on how to think about investing through uncertain times. Today, we will provide a quick refresher on risk vs. uncertainty, relate it to the COVID-19 world we currently find ourselves living in, and then explain how we combine this new framework with our approach to financial planning and investment management. We believe this approach provides a simple, logical process to address the priorities most important to our clients. Once we’ve established an understanding of these priorities, we can then implement investment strategies on our clients’ behalf to help them accomplish their goals and make decisions confidently.
Modern finance is built on the foundational works of modern portfolio theory (“MPT”) introduced by Harry Markowitz in the 1950s. The theory quantifies the risk of an investment by using the mean (average) and variance (standard deviation). A portfolio is then built combining several investments (diversification) where we can aim to maximize the expected return for a given level of risk. The expected returns are enhanced by the benefits of diversification—another key tenet of MPT and modern finance. The majority of investment professionals today, ourselves included, adhere to these core concepts of mean, variance, expected returns, and diversification.
We believe the MPT framework has, and will, remain valid for years to come. But this framework also has flaws which stem from the assumptions upon which MPT is built. MPT assumes that all investors are rational, have access to the same information, want to maximize returns, and have the same views on expected returns. Each of these tenets could be debunked separately, but the lowest hanging fruit that we can all relate to is “all investors are rational”. We all know people who likely don’t fall into that camp, and a new school of economics called “behavioral economics” has grown in popularity to explain the biases and irrational behaviors that people often have with money and investments. The emotions an investor has regarding their money virtually always affects their long-term investment results and risk-adjusted returns.
However, perhaps the biggest flaw is that MPT also assumes that asset returns are normally distributed. This is where the concept of risk is so crucial. Risk in a “normal distribution” is predictable meaning we can generally predict the average return, the range of outcomes, and the probabilities that are likely to result. This works when you have a simple game such as flipping a coin. If we flip a coin 100 times, we knowhow many heads vs. tails results there should be, and any differences can be explained through math—the outcomes are predictable and known. But, let’s take the real world where we have complex systems rife with geopolitical, economic, political, and social issues to consider. To assume real world outcomes follow a predictable, normal pattern seems questionable at best. Instead, we would say the actual outcomes are highly uncertain. These are “unknown unknowns” and hopefully this can help highlight the difference between risk and uncertainty.
Today, in a COVID-19 world, we have massive uncertainty as it relates to the virus, GDP growth, unemployment, corporate earnings, and the future recovery that the world is likely to experience. We believe this uncertainty also explains the elevated market volatility we are witnessing as the market overshoots to the up and downside trying to make sense of the “unknown unknowns” and find a new “true” intrinsic value upon which to stabilize.
So, how then should one manage assets through COVID-19 today and in future downturns? It all starts with having a solid game plan, and for our firm, we accomplish this through strategic financial planning. The planning we conduct is built around planning for better outcomes. If your assets are properly structured, meaning you have a ‘rainy day fund’ for immediate needs, potential emergencies and sufficient liquidity, you are already starting in a better place than most for the short term. But this is just the beginning, for we also want to plan for the long-term, and long-term planning is most directly affected by spending.
When going through the planning process, in addition to taking into consideration a client's time-horizon, comfort with, and ability to bear risk, we prioritize understanding:
Understanding these tradeoffs ahead of time and creating an agreed-upon plan gives our clients the playbook to navigate not only COVID-19, but also future periods of distress.
Having a playbook is a great start, but to be effective it must be implemented. And this is where our role as our clients’ fiduciary financial advisor and wealth strategist comes into play. It is our job to help our clients learn, execute, and adapt their plan over time while, of course, managing their investments to the playbook’s guidelines. This playbook also allows us to customize and build a more tailored investment strategy to manage through short-term shocks and to realize long-term goals. We have been developing a method to further plan for and protect our clients’ investments based on their unique playbook.
Going through the financial planning process is essential to provide the highest level of service. For clients of our firm, building this playbook is a complementary engagement to assist them in realizing their goals, and one which we hope adds value to what we already provide. I believe there is nothing more important that we could be doing over the coming months than going through this process, both as a checkup for a client’s the current investment strategy, and for the peace of mind that they are on the right track. It takes sometime to complete the planning process, but what better use of quarantine than preparing for your future.
If you have questions regarding a financial playbook for yourself or a family member please reach out to our office at 818.340.0157, or email us at firstname.lastname@example.org to find out more. We look forward to sharing our framework and to providing more of our community with their own tailored playbook and increased confidence in their future.