We have always lived in a world of unexpected and uncertain events. The challenge is how we enhance our confidence so we can achieve the life we envision? Do we manage a portfolio or comprehensive financial structure? Are we only focused on returns or outcomes? The issues are many and wide ranging.
In truth, we do not live in a world of “risk,” in which we know the game. We live in a world of “uncertainty,” in which the game is unknown. Managing “uncertainty” requires different tools to address our household risk. Our individual experience will be entirely unique, and our wealth management solution must address a comprehensive set of potential exposures.
What is the difference between risk and uncertainty, and why does it matter? Risk is when we know what game we are playing (like in a casino where we know the range of outcomes and chances). Uncertainty is when we do not know the game, like financial markets where the range of outcomes cannot be described in advance and the odds are unknown. Good decisions under risk do not necessarily translate into good decisions under uncertainty.
Financial markets are not only risky but also uncertain because they can deliver unpredictable extreme events of uncalculatable magnitude related to spontaneous factors such as wars, pandemics, unexpected financial shocks, natural catastrophes, and cyber events.
What types of tools work for risk management, and why do they not work for uncertainty?
Methods which assume that risks of complex financial markets can be well-described with statistical models have limitations. These approaches are suitable when we “know the game” but are unable to protect against the complex risks inherent to financial markets and individuals, and are vulnerable to establishing false confidence.
Addressing uncertainty requires a different viewpoint which is based more on financial structure. Managing risk in portfolios and seeking returns are just one piece of the puzzle. A better approach is to organize the holistic asset and liability structure.
Understanding the character of a your financial structure gives direction to build solutions to mitigate key risks, designate protective assets, and finally identify a portfolio with a balance between return and appropriate risky assets. Notice that the portfolio is the last step, not the first.
What are the types of tools that work in a world of uncertainty, in which the game is unknown?
Useful tools include insurance, diversification, liquidity management, financial offsets, true hedges (not hedge funds!) and lifestyle adjustment. These tools do not change what the world delivers, but they change how it affects an individual.
A robust financial strategy will consider how to reduce uncertainty for adverse events like acute financial distress, prolonged adversity, leverage, property, personal liability, health, death, disability, and job displacement.
Clearly consideration for likely events is imperative. But extreme event risks are also important even if they have a small chance of occurring in any given year. The small risk of failure becomes dangerous over long horizons. Extreme outlier events with a 1% and 5% chance of occurring in any given year have a 51% and 97% probability of occurring, respectively, within a lifetime of 70 years.
Everyone is vulnerable to such rare but extreme events. Specific circumstances can impact most households or alternatively a combination of negative shocks can disrupt any single household. This year has certainly provided us with an abundance of real life examples.
One immediate objective is to protect against acute distress and also to buy time to protect spending needs during job loss or other acute shocks, and finally to avoid selling assets at an inopportune moment. Having a cushion against prolonged periods of adversity is not only sound finance, it enables you to sleep better.
Another universal objective is to clarify the purpose of wealth and identify whether taking risk is necessary or useful. An example is retirement planning, for which the goal is to cover a base level of spending over an extended horizon, perhaps lifetime.
A thoughtful financial plan based on managing both uncertainty and risk actually empowers households to intentionally allocate money to what is most important and enables informed tradeoffs.
Have a plan. Have a strategy. Be confident in it so that you are not enticed to change due to the fads of the moment.