Unconventional wisdom: Don’t play Russian Roulette with your finances
Resilience is an underappreciated quality in a portfolio and life.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Don’t play Russian Roulette with your finances
“It doesn’t matter how frequently you succeed if failure takes it all away.”
- Nassim Taleb
Randomness plays an underappreciated role in our lives and our financial outcomes. Warren Buffett captured the role of randomness in an allegory about a coin flipping contest. Nassim Taleb used the more macabre example of a Russian Roulette tournament. Like any competition both coin flipping and Russian Roulette would end with a winner.
In both contests the last person standing – literally in the case of the Russian Roulette tournament – is praised for having great skill to come out on top. Yet it is obvious that skill is not needed to win. It is luck.
The outcome of each flip of the coin and pull of the trigger is unknown. We can calculate the probability that the coin lands on heads and the gun chamber is empty but the outcome is not known beforehand and the result is random.
To be an investor is to accept the role of randomness in the financial outcome you acheive. To be a good investor is having the humility to appreciate your powerlessness over randomness and focus on building a resilient portfolio to thwart misfortune.
Randomness in action
To show the impact of randomness I offer a simple question. You have three decades to invest during your working years. One decade will be a terrible time to invest and returns will be flat. One decade will be an average time to invest and returns will be 8% per year. One decade will be a great time to invest and returns will be 16% per year.
Over the 30-year period you will save and invest $10,000 a year. In what sequence would you place the decades? In every scenario the average return is the same. I’ve simply switched the sequence of returns. The following chart shows the results.
The differences in the outcomes from each scenario is stark. The best scenario is that returns are low as you start out and are contributing to your portfolio and then are highest as you approach retirement which accelerates compounding. A great investor may be able to exceed these returns in each of the decades by a percent or two. That doesn’t change the overall influence of the random environment you find yourself.
The market tends to go through good periods and bad periods. When they occur during your life is random because it is based on when you are born and when you start investing. During the first decade of the 2000s the S&P 500 had a negative return. The next decade the return was 13.56% annually.
How having it good can lower our financial resliance
We often don’t know how good we have it without the perspective provided by going through difficult times. And it has been a while since investors have gone through a prolonged difficult time. You may have lost perspective but I’m here to provide some – times are good and have been good for a while.
Chances are you know that investor behaviour is impacted by the market environment. And it has been a good time to be an investor since the global financial crisis. You’ve likely heard about Ben Graham’s Mr. Market and the insidious impact of fear and greed. But greed does not always manifest itself in obvious ways. Some people are going to indulge in blatantly speculative behaviour. But most people will just adjust their expectations and behaviour in more subtle ways.
If markets are surging people often become complacent about saving. This is known as the wealth effect. A study by Visa found that for every dollar increase in the value of assets people spent 34 more cents. A good deal of this new spending will be ‘locked-in’ which includes higher fixed obligations like car payments or mortgage payments. This makes it harder to adjust if market conditions change.
Above average returns may cause investors to mentally reassess the risk of certain investments. Thinking an investment is safer than it is may lead to a greater allocation to growth assets than is needed to achieve a goal. It could mean creeping out on the risk spectrum within an asset class by reallocating to more speculative shares. It could mean forgetting that higher valuation levels increase risk and simply chasing momentum under the assumption that the winners will keep winning. None of these moves scream greed. Yet individually or in combination they can make your finances less resilient.
How to build resilience into your finances
Given the influence of randomness on our financial outcomes I think it is worthwhile to strive for a financially resilient life. This will mean leaving some returns on the table. I think the trade-off is worth it if it lowers the risk a random event will put your financial position in peril. As Greek statesman Solon observed “No man’s life should be accounted a happy one until it is over.”
I’ve focused on building financial resilience into my life in three main ways.
1. I’ve minimised non-discretionary spending
A popular piece of advice is to spend less than you earn. That is a no brainer. But to build resilience into your finances you need to think about what happens if something goes wrong. That could mean losing your job, not being able to work or facing a pay cut.
I’ve done this by limiting lifestyle creep in my non-discretionary spending. Non-discretionary spending is the cost of staying alive – primarily housing and food. I’ve lived in the same apartment for the decade I’ve lived in Australia. During that time my household income has more than doubled as my wife did not work when we came to Australia. She has been promoted repeatedly since getting her first job in this country and I’ve also been fortunate to have my income grow.
In not succumbing to lifestyle creep the amount of our income that goes to non-discretionary spending keeps getting lower as our salaries rise. This doesn’t mean we are super savers. We just spend our money on discretionary items that bring joy to our life. Items that can be easily cut back if our incomes drop. We am very lucky to be in this position. My wife and I can more than survive on each of our salaries in isolation. We can survive on just income generated from our portfolio. Neither of those scenarios are what we want out of life but it does give us an added level of comfort.
My wife and I both make good salaries. We have chosen to not have children which makes our financial situation possible. Yet anyone can consider how lifestyle creep influences financial resilience. If you are younger and just getting by it might be a model to pursue as your salary grows. If you are older it might be something to consider as your evaluate your non-discretionary spending. As a bonus there are numerous studies that show spending money on experiences can increase happiness.
2. I hold cash
This needs little explanation. Cash helps me sleep at night. Holding cash means I never have to sell any long-term investments to meet a short-term need. Using cash in a bucket portfolio is how I de-risked my mother’s transition to retirement. It serves many purposes.
The rule of thumb is to have 3 to 6 months of expenses in an emergency fund. I have more than two years in cash. Every year I try and add a little more. Is this the best approach for maximising my wealth? It isn’t. But that doesn’t mean it isn’t the best decision for me.
3. I’ve built a resilient portfolio
Short-term volatility is not the risk that most individual investors face. People who equate short-term volatility with risk are not you and me. Academics who are trying to hypothesise about the market use volatility as a proxy for risk because it is easy to measure. Many professional investors who have different goals than you and me default to the same view.
It is common sense that risk is not the same thing as volatility. The implication of equating the two is that if an asset falls in price it becomes riskier. Any rational person knows this is nonsense. Don’t believe me? How about Warren Buffett. He said, “Volatility is not a risk we care about. What we care about is avoiding the risk of permanent loss of capital.”
If the risk faced over the long-term is permanent loss of capital than that is how you should assess the building blocks of a resilient portfolio. Permanent loss of capital can occur if a company goes bankrupt or if a bond defaults. It can also occur if you buy a share at a price that is vastly out of line with what the company is worth. That means that after a steep drop in price it may never recover.
How do I address this in my portfolio? To start I don’t buy anything speculative. I don’t buy anything I don’t understand. I buy large, established companies in non-cyclical industries that are in good financial shape, have low business risk, sustainable competitive advantages, and pay a dividend. Is this a boring way to invest? Yes. Is it the best way to hit a homerun with some short-term multi-bagger? No. A resilient portfolio may leave returns on the table compared to highly skilled or lucky investors. Life is about trade-offs. This is one I choose to make.
The second way I protect myself from permanent loss of capital is to focus on valuation. I’m not trying to calculate an exact valuation level. I’m looking at what our analysts are saying. I’m looking at measures like dividend yield compared to historic levels. I’m looking at relative valuation measures like price to earnings compared to the past. Just getting a ballpark sense of valuation is enough for me since I’m an income investor and focused on the sustainability and growth of dividends from predictable business models. I’m not trying to find the bottom for a share or buy something before a catalyst pushes the price up. I just don’t want to buy at a valuation so high that a drop in the share price is unrecoverable.
Historically my portfolio trails the market when it is flying high. It performs better when the market is tanking. I invest this way because I’m an income investor. In my retirement accounts I invest passively or in a passive proxy. That is something that any investor can do to address the permanent loss of capital. The ASX 200 or S&P 500 will be volatile but the index is not going to zero. Historically large indexes have always bounced back.
Final thoughts
Resilience isn’t sexy. It can’t compete with the popular portrayal of successful investors who stare down risk and are rewarded with mountains of cash. What is lost in this inaccurate portrayal is the impact of randomness on results. Don’t forget that when figuring out your own finances.
Please share any thoughts or topic suggestions with me at [email protected]
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What I've been eating
Every year in January I head down to Melbourne to eat pastrami. During breaks I catch some tennis. Pastrami originated in Eastern Europe and was brought to New York by Jewish immigrants. New York is where it came into my life. Beef brisket is brined, dried, seasoned with spices, smoked and steamed. It should be – and I can’t stress this enough – served hot. The best pastrami I’ve had in Australia comes from Bowery to Williamsburg in Melbourne. Bowery is the last subway stop in Manhattan on the Lower East Side before the train crosses into Williamsburg in Brooklyn. Both neighbourhoods were home to Jewish immigrants, and it is a fitting name for a restaurant with great pastrami.
