It’s a truism that investment goals are affected by numerous variables. It’s also true that those variables are too many to mention and difficult to predict. The modern information economy can expose us to informational biases: we’re overwhelmed by so much instant information that it’s sometimes hard to know how to respond.
Some historical perspective can be useful when selecting investment strategies to help you build up your savings for retirement. Here I’ve highlighted two important principles and introduced a third that helps to address them.
An era of financial repression
We are living in an era unlike any other in terms of economic history. Quantitative easing of the scale recently applied to most of the developed world is unprecedented. It will likely cast a long shadow on growth prospects in these regions. When this drag on growth is seen in the context of an ageing population the outlook for those looking to build wealth for retirement can start to look bleak. Why so?
Quantitative easing has two effects:
- It unleashes a flood of capital into the system that drives down the forward-looking investment return on all asset classes. It creates asset price inflation now and brings forward tomorrow’s investment return to today.
- It creates an indebted public sector which then in turn is hampered in its ability to support the economy with public sector spending (the so-called “crowding in” effect). These effects when added to the demographic problem can create decades of stagnation both in growth of the real economy and returns on financial assets.
Uncertainty and risk
If that’s not enough, investors still have to deal with the perennial problem of uncertainty. In his 1921 article “The Meaning of Risk and Uncertainty”, Frank Knight explained the concept of uncertainty as it affects investments. Uncertainty and risk are different animals. Risk is the statistical likelihood of a known series of outcomes. Therefore in investment terms we speak of risk often in the asset allocation of your investments (i.e. how much exposure you have to equities, bonds, property etc). The reason we speak thus of risk is because we’re inferring judgements about the performance and volatility of those asset classes from historical data. This is sometimes called the Beta investment decision.
Uncertainty, however, refers to the outcomes that could not have been known about in advance. We therefore can’t assign a statistical probability to the outcome of those events. These are the ‘black swan’ events that Nassim Taleb eloquently explained in his book of the same name. The failure of the hedge fund Long Term Capital Management in the US in 1998 is a real world example of uncertainty. By definition you’re unlikely to be able to take account of uncertainty in your asset allocation mix.
So what does this historical insight mean for your savings goals? Well, taking the long view shows us that today’s investment context is not all bad. Uncertainty has a positive element. Technology is transformative and is a good example of the upside of uncertainty. Microsoft, Apple and Facebook are all good examples of transformations that are wealth creating and yet could not have been predicted. The effect of technology on our society and the growth created is therefore a good example of a positive ‘black swan’ event. In fact, the presence of these events highlights the risk of not investing at all: you don’t know what you could be missing out on.
Therefore, despite the real and obvious challenges to growth in the developed world, the known outperformance of equities over time, combined with our ability to come up with new and interesting ways to create value is the reason you should invest. However, risk and uncertainty also mean that when you do this you need to be mindful of your personal context.
Alpha, Beta and now Gamma
David Blanchett and Paul Kaplan wrote about the importance of financial planning in 2013 in their article “Alpha, Beta and now Gamma”. They highlighted that financial planning is a vital (and often misunderstood) element of the investment mix. Their concept of Gamma refers to the additional value created by the individual investor when making good financial planning decisions.
“Unlike traditional alpha, which can be hard to predict and is a zero-sum game, we find that Gamma (and Gamma equivalent alpha) can be achieved by anyone following an efficient financial planning strategy.” (Blanchett, Kaplan, 2013) Part of the financial planning context is understanding how your income, asset wealth, tax position and debt levels all influence your capacity for loss. Risk profiles are often influenced by education. Capacity for loss is about your actual personal balance sheet. Your tax position depends on your mix of income, debt and asset wealth.
Bringing all of these factors into the investment decision mix ensures uncertainty doesn’t play havoc with your investment outcomes.
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