In the last post, I wrote about aspects of life that are predictable and the urgency of making wise choices in our own lives. While much is predictable, some of the most significant aspects of life are completely unpredictable. Each unique person born is the winner of a huge lottery, as we know from biology. Our lives begin in uncertainty, the course of our life span is full of it, and we meet our end at an unknown time and, at least through most of life, by an unknown cause. Such is the stuff of fatalism. What can we do in the face of all of this?
Life is full of uncertainty, from start to end, yet we are not powerless to deal with it. The ancient Roman playwright Terence wrote centuries ago, “Fortune favors the bold,” but does that mean we must take big risks to accomplish any goals? A more modern expression of this was said by the hockey champion, Wayne Gretzky: “You miss 100% of the shots you don’t take.”
Life’s turns, positive and negative, are most often out of our control. Meeting someone new. Getting in an accident. Getting or losing a job. Getting sick. Winning the lottery. The decisions we make in the face of these events influence our future opportunities and choices. A chance encounter can result in meeting our spouse or getting a new job opportunity. A boss that doesn’t like us can stunt our career or force us to look at new opportunities. A market downturn can make us worry – or actually become – unable to retire. These turns in life are often accompanied by strong emotions, and with them, cognitive bias can hamper our decision making. These biases can even cause us to make poor decisions that we regret years later.
Money is an emotional topic, so biases are everywhere. For example, loss aversion bias: the greater the consequence of a loss becomes, the less likely we are to risk it, even if it is statistically wise to do so. This is a flaw in most risk questionnaires used by financial advisors. “Would you rather invest in a fund with 1% chance of a total loss next year, or a fund with a 50% risk of a 10% loss?” Even if the upside is the same, people will invariably choose the second choice, although statistically, that is not the wise choice. But this is oversimplifying things when it comes to investing.
Another type of bias is recency bias. Investors were very confident that there would be good returns in the stock market for 2020 back in January, but by April, many people were expecting a terrible year in 2020. Today in August, the market is trying to make new highs. In the short term, the market is completely unpredictable, but it is more predictable in the long term.
When we perceive we have fallen behind or are off track (whether correctly or not), we take larger risks. This is the gambler’s fallacy. There are many otherwise prudent people frantically trying to beat the market, to make up for the decision to sell at the bottom this spring, and pension funds, who are still trying to catch up after 2008.
Some risks are only incidentally financial: an early death can be compensated monetarily by life insurance, but nobody can replace a mother or a father that is lost. That loss changes the lives of all the family members forever.
How can we manage risks? We cannot know the date of our death, or even what the tax code will be next year. However, we can eat better, exercise, save more, spend wisely, and prepare for changes we know will inevitably come. If this sounds boring, that is why most people do not do these things.
The first principle to managing risk is to understand the bigger picture. What are the risks we face, and their consequences? Take an inventory and devise a plan to address each one. If people depend on your being able to support them, you very likely need life and disability insurance. These steps will help you and your family compensate when something happens out of the blue.
A second principle: Get an outside perspective. Educate yourself, and then remember when your emotions get the better of you, you can make destructive choices. Team up with an experienced prudent advisor in life. Financial, insurance and investment professionals can be of help with technical aspects, but there is no substitute for a mentor or family member who will always have your best interests at heart.
The third principle: Have a plan that is based on a known successful approach. Know that all plans go out the window when you get punched in the face.
Finally, don’t necessarily change the plan when things aren’t going the way you want them. The principles above will help accept the situation when things go badly. A wise and prudent plan makes it most likely that you will be able to get up one more time than you are knocked down.
Time is Fleeting – Part 2 of a Series