Probabilistic Investing

December 11, 2017

One of the things I appreciate the most about Vanguard is how they approach their market outlook when it comes to making an economic forecast. Many firms try and give an exact figure, i.e. an 8.3% return in the S&P 500 for 2018. If I believed that it was possible to accurately predict the markets with this degree of precision, it would make investing incredibly straightforward. However, history has proven that the world is dramatically more unpredictable then the experts might lead us to believe. 


While making an exact prediction might seem impossible, that doesn’t mean we should simply throw our hands into the air in exasperation. A better approach is to think in probabilities. I will use Vanguard’s recent publication as an example with the corresponding appropriate investment strategy. 
 


There is even some risk to the accuracy of our guesses of each scenario but it is at least a reasonable place to start. When we build our investment strategy for the next year, we must accept that each scenario is a possibility in 2018. For those out there that are convinced that next year will be a recession, they will build a very conservative strategy. The problem is for those people, we put those odds at only about 1 in 5 and a very conservative strategy would do very poorly in the other two scenarios. Something similar would happen if someone was very optimistic about the markets for next year. What our analysis shows is that by simply building an appropriately diversified portfolio, that is not only the best strategy for the most likely event but also is never the worst strategy if the other scenarios come in to play. In our minds, this one of the best way to mitigate risk over the long term when working towards your goals. 
 

 


If this seems a little overly complicated maybe think of it in this way. You are going to Disneyland tomorrow and need to get ready. Most likely it is going to be about 70 degrees. There is a small chance (20%) that it is going be really cold around 45 degrees. There is also a chance (30%) that it is going to get hot around 85 degrees. If we knew exactly what the weather was going to be, we would dress perfectly. But just like investing, the weather is tough to predict. We might be scared it is going to be cold but dressing in long johns and a heavy coat seems like a recipe for a terrible day if it doesn’t turn out cold. If it’s going to be hot, shorts and a shirt would be the best way to go but that is going to make it rough if it does turn out to be cold. Instead, the best approach would be to come in something like jeans with a shirt and maybe a light jacket or sweatshirt. If it does turn out to be cold, we should be in pretty good shape. If it is hot, well it will be annoying to carry around the jacket but at least we were protected from the other scenarios. 


While the metaphor might be a bit simplistic, it is not far from the healthiest way to approach investing. Investing for specific scenarios is too risky in our opinion for most investors and it is better to be ready for all situations that might come. We might not be optimized perfectly for what comes next but we will still do well and protect ourselves from the greatest mistake of being straight wrong. 

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