The decisions and trade-offs that you make will shape your financial future.

Most of us cannot have it all. Wanting more of one thing usually means settling for less of something else. If you are not willing to accept the volatility of markets, you probably need to reassess your needs that require funding.

Nobody is going to bail you out with quantitative easing or an economic package to help you with your liquidity concerns in your personal life. Your private economy is …. well private. There are no reliable external interventions unless you are banking on an inheritance or the Lotto coming through for you.

Investors have two fundamental risks that will determine their future outcomes:

1. Longevity risk – the risk of outliving your capital.
2. Inflation risk – the risk that you will increasingly be unable to fund a set of needs with the same amount of money.

The only reliable “economic package” for investors has been exposure to and time in the equity markets. Market exposure has historically provided the growth and inflation beating returns required to manage these two fundamental risks. The caveat has always been that it comes with price volatility. Markets have always gone up – and down. The pain of the down cycles has always been temporary and the benefits of the upswings of a more permanent nature.

Markets have historically moved to new highs after painful downturns. This is a feature of the market. You are rewarded for accepting this risk. You have a reasonable expectation for a superior return over cash in time. Take away the volatility risk and the higher return also disappears.

The desire for a high return, low risk portfolio is what Ponzi-schemes are made of. It feeds on the false hope that gives investors great comfort. The desire for short-term comfort usually translates into long-term suffering. When we misbehave at market extremes, we transform short-term money worries into long-term money troubles.

Unless you saved aggressively over time most people don’t have much of a choice. The heavy lifting is done by the investor through making regular contributions. Market returns will come. Most people cannot save enough money to fund 30 years’ worth of cash flow needs without market growth.

What would be more uncomfortable?

• Sitting through the temporary downturn in market prices.
• Not having enough money to fund your future needs.

Which one of these two realities would be the worst experience, the one you would least want to suffer through? It is your choice. If you draw an income of 5% or more of your capital, you need to have an equity centric portfolio. Not having enough equity exposure is the big risk. You get closer to your “enough” when you accept the uncertainty of equity markets. If you cannot live with the volatility, then you need to reduce your needs. There is no magic here. It is intentional choices made with awareness.

Every market downturn in the last 25 years felt like a “this time it’s different” event. Experience has shown that it was not. It usually feels like the end, but it’s not. We always have great explanations after the fact with the benefit of hindsight.

It is human to prefer false certainty over the discomfort caused by the lack of certainty.  In the short term the markets are uncertain. By selling out of markets in the short term you introduce greater long-term uncertainty. This behaviour historically had a negative impact on future goals. Trading the pain of market volatility for short-term comfort historically has always been a poor decision.

“Great results in equity investing proceeds from avoiding a few awful common mistakes. People accept the basic principles but find it difficult to practice them no matter what is happening in the world and the markets.

It is not the process that fails, its people’s inability to maintain composure and commitment. If you add time to composure success will be inevitable. History is our only guide to go by. Wealth is less a function of what you know and more about what you do.”

                                        – Nick Murray (Simple Wealth, Inevitable Wealth)

Being a pessimist in times like these sounds very smart. It appeals to people because it usually implies risk avoidance. Optimism sounds foolhardy. By removing market risk and volatility in the short term you increase the real risks that are long-term in nature.

“Optimism often sounds like a sales pitch; pessimism sounds like someone trying to help you.”

                                          -Morgan Housel

Our job as advisors isn’t to shield investors from temporary volatility. It’s to put them in a position to survive it (both financially and psychologically), in order to reap the rewards. We know markets are going to occasionally go down, and need to plan accordingly.

Advice has little value if you cannot get the client to follow through on the advice.

 

The above article was written by Marius Kilian.