Future Testing

Much financial news purports to be about the future but is really just an account of the past. As a result, many investors project what has already happened onto an imagined future. There’s another way of framing this problem.investors future financial planning

It’s understandable that investors, with the help of a necessarily short-term-focused media, will tend to focus most of their attention on what has happened in financial markets in the past month, week, day or even hour.

When stocks have fallen heavily in price, for instance, this is routinely reported as “more bad news for investors today”. In fact, unless you plan to liquidate your portfolio that particular day, it is unlikely to be bad news at all.

The media could just as easily say “stocks went on sale today, as falling prices offered investors higher expected returns”. If you are a long-term investor, the key issue is how your portfolio performs from now on, not what happened yesterday.

In this way, investment is about the future, not the past. And because the future is unknown, we should manage the uncertainty by diversifying across stocks, sectors, asset classes and countries. To do otherwise is to take unnecessary risk.

The second assumption the financial media makes is that the future is the same for everyone. But, of course, our futures diverge depending on our age, our family circumstances, jobs, incomes and a myriad of other factors.

One person may be focused on paying for the approaching college education for their children or caring for aging parents. Another may be looking towards buying a home or saving for a holiday or investing an inheritance or changing career.

Everyone’s future is different, which means the investment strategy each of us adopts will vary. Some will want a strategy that delivers regular income; others will be more focused on capital growth. Some will be risk-takers; others risk-averse.

From this, it should be evident that if the future looms differently for each of us, risk is not just one thing. Risk is not just the volatility of the market day to day. It is not a simple statistical metric that can be measured. Risk can be felt differently depending on your age, your dependents, the industry you work in, the country you live in, the currency you consume in and your accumulated assets and liabilities.

This is why an assessment of the future and the uncertainty surrounding it should not just be approached from the level of the overall market but from the needs of each individual. And that is the role of a qualified fiduciary, to help connect each individual’s circumstances and needs to their goals.

None of us can control the future. Risk can be quantified up to a point, but risks can vary greatly depending on the individual. In any case, there are other uncertainties that cannot be analysed in terms of mathematical probabilities.

One response to future uncertainty is to speculate and to try to position one’s portfolio to take advantage of one possible outcome or another. The risk in taking that approach, apart from getting it wrong, is that we can end up acting on stale news or paying a premium to take advantage of news that is already in the price.

Another response is to stay highly diversified and to use the information in market prices to stay focused on the reliable dimensions of expected return.

This latter response doesn’t require speculation or forecasts or second-guessing the market. It just requires an understanding of what we can and cannot control. So while we can’t control the future, we can control the structure of our portfolios, we can ensure we are broadly diversified, we can manage fees and taxes and we can regularly rebalance to ensure the risk allocation stays within our chosen parameters.

Yes, the future is unknowable. And how it unfolds has differing implications for each of us depending on our circumstances and needs.

In the final analysis, while we cannot prepare the future for our portfolios, we can still prepare our portfolios for the future.

 

Written by Jim Parker, Vice President, Dimensional Fund Advisors Limited

Image courtesy of Boians Cho Joo Young / FreeDigitalPhotos.net

 

About Rob Pyne

Rob loves helping people make smart choices with their money so they have the highest probability of achieving their goals. He does this by helping them get financially organised and keeping it that way.

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