Investment Wisdom for Building a Better Life: Focus Your Predictions on What You Can Control: Your Priorities
- Apr 1, 2010
Predictions are part of investing, and yet they are frequently misapplied or misunderstood. What purpose do predictions serve? How do predictions help us to make better decisions?
History—the past—is something we know with some certainty. But there's an ever present mystery about what's ahead. No one knows what's going to happen in the future. We can make assumptions. We can speculate. We can guess. But ultimately, we all have to admit that we're not clairvoyant; we can't foretell the future. What we can do is study the past, identify patterns, and then apply the knowledge of patterns to the present. Still, our financial planning will be built more solidly on personal goals than on predictions dictated by history.
At certain times, predictions make sense. For example, if you leave a piece of unprotected steel exposed to the elements for an extended period, you can expect it to rust. That's a safe prediction, so you'll want to paint the steel or protect it in some other way to avoid the rust. Because your prediction of rust is based on scientific evidence, there's a strong likelihood it will be accurate.
That kind of predictability goes out the window in contexts having less consistency than steel + moisture + time + oxygen = rust. The financial market is just such a context, buffeted as it is by a host of variables. There's what's happening with investors...with a company...the international markets...the direction of interest rates...where the economy is going...the political environment. Various shifting factors influence our ability to make predictions.
When you think about all these variables, you may ask yourself, "Do predictions have any validity at all?" They do, but they need to be informed predictions based on factors over which you have some control.
Predictions need to be seen for what they are. They are a series of carefully calculated assumptions based on patterns of the past. They are one piece of what goes into the investment planning process. The other components are also important, such as having an asset allocation strategy, managing risk, actively saving, having reasonable goals and expectations for market returns, and reviewing performance.
No matter how well you feel you can make predictions, you cannot be certain. Even an informed advisor can't be sure because investing involves continual oncoming blind curves. Advisors can't see around those curves any more than you can. It's unrealistic to expect that they can. What advisors can do is apply their experience with blind curves to new events. They have been down this road or one like it previously, possibly hundreds of times, so their level of familiarity is likely to be higher. People who have studied the financial markets for many years have learned to recognize and take note of patterns. Even though history does not repeat itself, as Mark Twain said, "it rhymes." So the patterns have similarities. For example, we can pinpoint moments of irrational exuberance, such as in late 1999 during the Internet craze. We can also highlight moments of deep depression and hopelessness, such as the stock market trough of October, 2002. In short, the experience financial advisors have with patterns gives them a context to work with—a context that makes the unfamiliar appear, to some extent, familiar.
An advisor can study developing trends, identify trends that are in place, and make assumptions about the potential longevity of each trend based on history, science, and mathematical probability. As these trends age, an advisor can estimate the risks involved in continuing to participate in the trend and make adjustments for the inevitable new trends that lie ahead. But remember, all the information we have about market trends is based on only 100 years of history. The stock market was not started until the early 20th century, and so all the possible blind curves have not had time to reveal themselves. There are more to come!
You can accomplish a great deal by making predictions based on reliable information. It's when there's a clairvoyant component that predictions become unreliable. An advisor's crystal ball has plenty of cracks and clouds, just as yours does! Questions like, "What do you think the market's going to do?" and "What do you think the Federal Reserve will do with interest rates?" are far from the scientific element. The answers tend to be unreliable because they're based on variables over which you have no control.
When it comes to your investments, you need to make the right kinds of predictions—using tools based on historical patterns, scientific evidence, and mathematic probability. Even then, you need to make those predictions with reasonable expectations. In other words, you can't rely on predictions alone to make financial decisions. You need an investment strategy with a contingency plan built in.
Here is an exercise to consider: Imagine what a portfolio might look like with an investor's goals ranked as follows:
- Financial security
That's Person One. Now let's look at another person's list.
- Financial Security
That's Person Two. Do you see how these two people might have two substantially different investment strategies?
Look at Person One first. If financial security comes first, what is she going to be most concerned with regarding her money? Not losing it! If family comes next, she's going to want to have a family estate plan in place. If health is third, perhaps it's of some importance, but she might skip some health related steps if she's worried about spending too much money. (Remember, in her priorities, financial security comes first.) Hobbies were last, so although she probably has some enjoyable activities, if she had to live without them she could. She may also be putting the hobbies of other family members ahead of her own interests. Her financial strategy needs to reflect her priorities.
Now let's look at Person Two. His first priority is his career. At the start of each day, his first thoughts might be about how to get ahead, increase his compensation, get more notoriety, or receive credit for his accomplishments. He may feel he can invest with some degree of abandonment because his career is being launched successfully, and he doesn't need any income from his investments. For this person, hobbies are the second priority. He works hard and plays hard. Financial security is the third priority. Maybe this person realizes that he can't work forever, so he decides to save a little money. Nevertheless, because of the way he's ranked his priorities, he's not giving up his hobbies, and it doesn't matter if those hobbies jeopardize his security a little bit because his hobbies are a higher priority than financial security. Family comes fourth. Because his career comes first, he might not give a lot of thought to family life. This is a very different profile than our first example, Person One.
It can be enlightening to do the following exercise with your spouse and with adult children who would like to participate in the process. Give everyone 20 seconds to write spontaneous answers to some questions. Warm them up first with a few fun and random questions, such as:
- What are your favorite colors?
- What are your favorite birds?
- What is the best month of the year?
- What is your favorite time of day?
Limit everyone to 5 to 10 seconds for their responses. When they have the hang of it, ask them this question:
- What are your most important priorities, in ranked order?
Have them rank their priorities. If they need prompting, offer them suggestions as to what they might include:
- Financial security
Here's where it gets complicated. When everyone writes down an answer, the next question is the most interesting:
- Is that what you are living?
The answer is not always yes. This is a critical lesson to apply to your investment strategies, which may be misaligned with your priorities.
After you rank your priorities from a financial perspective, you can start taking some control over the way you handle your investments. What if health is one of your priorities? What actions are you taking with your own resources to get yourself in the best health? Are you exercising frequently? Are you a regular participant at a gym? Do you maintain a healthy diet? Do you know the details of your health insurance, such as the terms of your co-pay and quality of services? Have you made a commitment to your physical well-being, and is health care an integral part of your life?
From a career standpoint, does your career offer strong financial potential? Are you focused on how you can enhance your levels of achievement?
In your family, are your children being well educated? Are their emotional needs being met? Are they going to summer camp? Do they have expensive hobbies? Are they going to college, and are you going to pay for it? Are they planning to intern in the family business in preparation for a career there?
As you consider your priorities, you are making financial connections, discovering what actions you should take and how your investment strategy should be refined. As a result, your strategy will be based on what's important to you. Any predictions you make are related to what's true about you—and your strategy is based on so much more than just predictions.
Your investments should serve the higher purpose of getting you as close as possible to your most important goals. Therefore, you need to be connected to your investments. You can design an investment strategy only after you know what's important to you—your highest priorities.
You can't predict what you can't control. So don't make all your investment decisions based on predictions. Make them by having an investment strategy based on your true priorities. Ironically, after you integrate your priorities into the mix, your investments will have a much higher probability of being successfully predicted!
In case something unexpected should happen, you also need to have a contingency plan. What would you do if things did not go the way you expected? Let's say you rank your career first on your list of priorities, indicating that your career is of the greatest importance to you. You've invested heavily in your career and made a long-term commitment to it. Because career is high up on the list, you're relying on the income it generates to drive your investment strategy. But what if something happened and you lost your job or were injured? In that case, your career would be unable to fulfill that role, and your investment strategy would have to rely on your other priorities.
You have options at this point. You might accumulate enough money to prepare in advance for this event. You might have adequate health, life, and disability insurance. These are only a couple of the strategies that contribute to a well-designed contingency plan.
When you have a solid contingency plan guarding your priorities, your ability to predict your future has an added boost of support. When something goes wrong, you don't have to stop and think about how to handle it. You rely confidently on your contingency plan and make very quick adjustments.
One investor, Brian, had personal experience with this.Saly:
What kind of a contingency plan did you have when you first contemplated retiring, and how has it worked for you?Brian:
I worked in sales in the grocery business for many years. I've always enjoyed my work. It's not that I wanted to retire. I just wanted to take it easy a little bit. I always thought my profession was recession-resistant. People have always needed food! As I began to downsize my business activity, my advisor reminded me that I needed to put some additional cash aside just in case my income would fall unexpectedly because I wasn't putting the same effort into my work that I once was. At the time I remember thinking that this seemed overly conservative, even gloomy. I wondered if it was even necessary. After all, it wasn't like I was quitting. Then this most recent economic downturn came around, and I have to admit, sales fell off. I started to wonder if I could even keep the work I had been doing, even though it was scaled down. I was concerned that my job might actually be eliminated. I realized that having an emergency fund was a great idea. Although I never needed to tap my investments, it was a great feeling knowing the funds were there. As it turned out my business didn't suffer in a major way. The market change and my concerns were temporary. I never really felt the pressure that my friends have who are my age and still working. I think it's because I had a cash cushion and they didn't.
To summarize, you can't predict what you can't control. You can make some predictions, and an informed advisor can help you make even better decisions. But it's unrealistic to rely solely on predictions as an investment strategy. A more reasonable approach is to design an investment strategy around your ranked priorities, with a contingency plan to back it up.