Investors typically look for 2 crucial features in their investments:
- Their investment must not lose money
- Their investment needs to keep up with inflation
You realize that… #1 and #2 are often polar opposites. In order to not lose money, we can put our money in cash-like financial instruments.
However, if we do that, the common gripe is that these cash-like financial instruments do not keep up with inflation.
So we cannot have both critical investment features.
The opportunity cost of #1 is that you cannot have #2. The opportunity cost of #2 is that you cannot have #1.
In order to have both, we needed to combined different financial instruments that have more features of #1 and more features of #2 into a combined portfolio.
If we sit on the investment over a long duration, you hope that it gives you a greater chance to have an investment portfolio that does not lose money and keep up with inflation.
However, there are no perfect financial assets.
You always need to forgo something.
In an investment portfolio made up of different financial assets, you have to bear with volatility and uncertainty. Volatility and uncertainty that in the short term, you have that uncomfortable feeling that you are unsure if you are doing the right thing by investing this way.
By now, you may finally realize what I wish to drive across: There are always trade-offs in this investment world.
You may be facing the same trade-offs right now.
The double whammy of the COVID-19 event and the oil crisis have brought about a significant market correction around the world.
This presents a host of questions that may exist in your head:
- This is a rare opportunity to give my investment a boost by buying low
- Should I add now? Perhaps it can go lower still….
- Should I sell my holdings and buy back lower?
The objective answer to these three questions is that there are trade-offs.
This can be a rare opportunity to give your investment a boost by buying low, but it could also be that this is an event that would end up worse than the Great depression and longer than expected.
You can choose to add now, but there is every chance the price will get cheaper. While you may have gotten the investments cheaper, you will still have to bear the volatility, the uncertainty and the uncomfortable feeling of not sure whether it will work out.
Finally, you could sell your holdings and buy back lower, but what if this is the bottom?
A lot of these questions can be answered if we have a crystal ball. The problem is… not many people have one.
How can we de-conflict these few trade-offs in our investments and make clearer investment decisions?
Mohamed El-Erian’s Guiding Principles
Perhaps Mohamed El-Erian’s two question framework could prove useful to help us untangle this.
Dr. El-Erian is the chief economic adviser at Allianz, a global investment firm. Prior to this, Dr. El-Erian serves as CEO and co-chief investment officer at PIMCO, a massive active-fixed income management firm currently managing almost US$2 trillion in assets. He also served as chair of President Obama’s Global Development Council from 2012 to 2017.
Dr. El-Erian was on Morningstar’s podcast The Long View to discuss the policy response to the coronavirus. You can read the commentary of the podcast here.
At the end of the episode, Dr. El-Erian was asked what should investors do in a time like this.
Having managed a lot of other people’s money, through very turbulent markets such as in the Emerging Markets, Dr. El-Erian finds that answering these 2 simple guidelines can simplify decision making.
Dr. El-Erian believes that the average investor has too much information during periods like this.
They ‘drink’ information from 3 firehoses:
- All the information that is bombarding them about the markets, about their portfolio and people seeing things that they have never seen
- What we see in our daily lives (about the coronavirus and how it affected our lives)
- Every hour there is an emergency policy implementation
Dr. El-Erian believes that a lot of the conventional wisdom of portfolio construction remains valid. However, as investors, advisers or portfolio managers, we need to be wary about “the extremes”.
Behavioral economists will say that in times like these, we are taken out of our comfort zones. This is in terms of what we are seeing, what is happening to our investments, what we are seeing to happen to ourselves.
We are way out of our comfort zones. In these situations, we will have 2 reactions:
First, the individual investors, advisers and portfolio managers need to know that it is natural to feel unsettled and uncertain.
We can have a few principles to guide us.
By asking ourselves certain questions, it might help us in our decision making.
The First Question
The first question to ask yourself:
- I know in this uncertain world, no one can predict that the likelihood of mistakes will go up, no one wants to make a mistake but which mistake can I least afford to make?
- After going through 2008, we know that most mistakes are recoverable but what are the mistakes that I do not wish to make?
This is a question about each of our:
- asset allocation
- tolerance to risks
- the timespan we think of in terms of our investments
The opposite way of thinking to thinking about the mistakes we do not wish to make is thinking about what are the decisions that will go well for me.
Answering this question will guide your further decision-making.
The Second Question
The second question center on regret minimization.
Dr. El-Erian believes that our decisions should be based on regret minimizations. We will face trade-offs now such as
- Do I leave money on the table?
- Do I sell to protect my portfolio?
- Do I buy, now that prices have sold off quite a fair bit?
- Do I wait for the bounce to buy?
If I ended up making a mistake (which I do not want to make), which mistake would I regret less?
The Answers & Decisions You Make Are Personal
People don’t like to hear the answer “it depends…”. It feels like a cop-out answer.
However, in reality, a lot of decisions we make are highly personalized. Dr. El-Erian ends of the podcast segment by saying the answers to these two questions can only be answered on an individual level.
Your financial plan is highly personalized. We made recommendations specific to your family’s unique situation. The decisions you should take with your money should be specific as well.
Rules, frameworks, and processes like what Dr. El-Erian provides helps guide our decision making.
Both of Dr. El-Erian’s questions has elements of financial risk management in them.
An Example of Decision that I May Regret Dearly
The first question tells us not to violate certain risk management boundaries.
For example, suppose I can tell you that I am rather risk-averse.
I do not really like to see my wealth go down more than 20%.
Given the volatility we seen recently, I am glad that my overall asset allocation reflects my true risk tolerance, with a higher weightage to bonds.
One decision that I will need to contend with is whether I should rebalance my bonds to equities and take advantage of the low prices.
I am 3 years away from my financial independence. I have more or less accumulated what I need.
The risk here is that if I rebalanced too much from bonds to equities, and equities may take a while too long to capture the returns, this may jeopardize my financial independence.
The mistake that I do not wish to make here is jeopardizing my financial independence. The right thing to do is to rebalance but not to such an extent that my portfolio is at risk of losing so much value that I have to delay my financial independence.
An Example of Decision that I will least Likely to Regret
The second question is highly personal because each of us will regret different things.
Some of us will die inside if we realize that we missed out on this “once in a lifetime opportunity”.
Some of us will feel very regretful if prices go down further and they have already deployed a large chunk of their excess funds.
Asking the question of what you will regret less of makes us evaluate our decision specific to our own temperament and our own situation.
For example, suppose I am an accumulator right now.
I have 20 years more to accumulate. I see my portfolio go down 30%.
What would I regret less of:
- Pulling out my money, locking in the losses, only to see it recover to where it was at year-end or
- Staying invested and seeing my hard-earned money go down even further
The answer to this question of Dr. El-Erian is that it is usually more nuanced. As an accumulator, what you have accumulated currently is not enough for what you need it for. Your losses may be the equivalent of 6 months, 1 year or 2 years of your annual surplus from work that you allocate to investing.
If prices continue to come down, your current holdings may suffer more. However, the annual surplus you will invest in these few years would be at very attractive prices.
Both your current holdings and your new investments have adequate time horizon to capture the returns needed.
In contrast, if you sold off your money locking in the losses, prices could languish for a while and you would wait for the “recovery” to happen. Market recoveries and false dawns both look pretty similar. You may realize that you end up playing a long waiting game.
Before you know it, you realize that the market has recovered. You have locked in losses and for you failed to invest your existing surplus from work income at attractive prices.
If we frame the two choices this way, #2 is the one you may regret less.
The Role of Planning
In both of my examples, you realize how important the fundamental financial planning framework is to support your decision making. Fundamental financial planning helps you risk manage a lot of aspects of your financial life.
It lets you know
- how much you need
- what each dollar you own does to steer you to your dreams
- how long of a runway you have till you need the money
- your risk tolerance
The decisions you do not wish to make is to derail your plan. If your plan is intact, whatever decisions that you make with additional money should not make you regret so much.
Dr. El-Erian’s illuminating questions try to link your actions, desire with our traditional risk assessment of your ability to take risks and willingness to take risks.
Let me know your interpretation.
The article you have just read is part of Providend’s Think Space- a repository of content which we research about and reflect upon in bid to provide only the best solutions and recommendations to our clients.
Think Space is narrated currently by Kyith Ng. Kyith is a Senior Solutions Specialist at Providend, Singapore’s First Fee-only Retirement Financial Adviser.