164. (12. Building Finance Intuition) the world dances to its own tunes
“The best-laid plans of mice and men often go awry.” — Robert Burns
Over the last couple of months, I have been writing on what I believe to be the major categories of impediments to wealth creation. I started out with the most naïve looking but the most insidious of impediments which is “Ignorance”, followed by a number of everyday causes each of which may not account for much but in combination can cause a significant dent to your wealth creation journey. This was followed by how our own humanness — our cognitive endowments which distinguish us from the rest of the animal kingdom — may stand irresolutely on our path to financial prosperity. Then I wrote about how our transitory moods and energy levels play a dominant role in our financial decisions and finally, on how our fickle perception of the world casts a long and deep shadow on our financial decisions.
In this blog, I’m going to close out the topic of impediments to wealth creation with what I believe to be the last of the major categories — how the dynamism of world can lay waste our best laid financial plans and decisions.
According to the research presented by Vaclav Smil in his book “Grand Transitions”, in the early 1900s, electric automobiles were advertised as “absolutely safe, perfectly clean, best to ride and most economical to keep”. By 1899, for every two gas-powered automobiles, three electrical automobiles were produced. There was a strong general consensus that electrical vehicles were going to be the future. It took less than ten years for this consensus to completely unravel. Gas-powered cars completely took over the market.
Even the most careful plans can and often do come apart.
“The best-laid plans of mice and comedians usually wind up on the cutting-room floor.” — Jon Stewart
In theory and hopefully in practice too, we learn and understand the levers of wealth creation, conduct a DIY planning exercise or work with an independent financial planner in arriving at a suitable plan and follow through on the identified actions. Later, we periodically review our progress and make corrections as required. Having done all this work, we expect that we will achieve our financial goals. Fair enough but we may not end up so.
Why?
Because the world around us sings to its tunes. Because happenings in the world do not follow deterministic laws like Newton’s laws. Sometimes they do (perhaps!) but many times, they just seem like they do. In almost all situations, outcomes can only be extrapolated probabilistically. There are no guarantees. An action need not lead to a consequent result. Action only makes a result likely but not consequential.
As an extreme example, consider “heat” — it flows from a hotter substance to a colder substance. But this is not a natural law. It is possible that heat could transfer from a colder substance to a hotter substance, ever so briefly. It is just that this is very, very (and very, very…..) unlikely. It is so unlikely that we need not ever consider the possibility of heat flowing from a colder object to a hotter object.
Back to personal finance: over the long term, investments in equity are highly likely to give better returns than fixed income instruments but this is not guaranteed. There is no way to predict events such as Ukraine war or COVID-19 pandemic which could tank stock markets.
If you can’t be sure that intended results are guaranteed, how do you go about your wealth creation journey?
“In nature there are neither rewards nor punishments; there are consequences.” — Robert Green Ingersoll
One way to address this is thinking in terms of consequences. I was fortunate to develop this kind of thinking after reading Nicholas Nassim Taleb’s book “Antrifragile”.
Let us say that you did some back testing and determined that investing in a broad market diversified index fund may give you compounding returns between 8% and 15% per annum with highest likelihood for 12%. Given that 15% is wishful and 8% is too pessimistic, we naturally tend to use 12% in our planning. So long as the future unfolds with 12% return or better, we will be able to meet or better our plans, but our plans may go astray if returns turn out lower than 12%. To remove this fragility, it is better to use 8% as your planning input. But, in reality, future is anybody’s guess. So, returns may turn out lower than 8% as well. So, it will be better to use an input lower than 8%. How low do you go? No good answer. Any input can be invalidated by the arrow of time. The bigger point here is to realize that it is best to account for adverse outcomes — in other words, marginal utility of ascertaining the likelihood of an outcome dwindles rapidly. In terms of consequences, even if you go with what you believe to be the most likely estimate, you will be better off being prepared for the consequences of your estimate going wrong, perhaps very wrong.
“Everybody, sooner or later, sits down to a banquet of consequences.” — Robert Louis Stevenson
How early do you start for the airport to catch a plane? If you did not provide for any buffer for potential traffic jams on the way, you better be OK with the consequences of missing the flight.
The more adverse your consequences of getting wet, the more important it is that you still carry an umbrella, even if the forecast is for low chances (say, 15%) of rain.
So, if you are investing a certain amount of capital in a volatile instrument, it will be prudent of you to set aside sufficient capital in safe (less volatile) instruments such that you will be able to ride out periods of high volatility of the riskier investment.
Bottomline
“Wisdom consists of the anticipation of consequences.” — Norman Cousins
Despite careful planning, you may still fall short of your desired results. This is because there are simply too many variables that affect the future and most of these variables are interdependent — so there is no analytical way to project their future values. This implies that as opposed to tethering your future entirely to most likely outcomes, it is prudent to account for consequences of things turning out adversely, because things may and often do turn out different from what we expect. A great plan is one which positions you for success, at the same time ensuring that you will not be forced out of the game, just in case things fall apart.
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