Generally speaking, there are two types of investors:
The first are investors who believe that they must do a better job forecasting the future than other investors in order to win. We’ll call this group the predictors.
The second group are investors who believe they should focus on what they can control, instead of trying to predict the future. They recognize that the future is uncertain and follow the age-old advice of “hope for the best, but be prepared for the worst.” We’ll call this group the preparers.
Let’s talk about the predictors for a second, as I would argue most investors are members of this group.
Predictors believe that the primary determinant of their success is the ability to predict the future.
In order to successfully grow their portfolio, for example, they feel that they must know where Apple’s stock price is headed or whether emerging markets are poised for growth.
Likewise, to avoid financial disaster, they believe that they must peer into the future and see the stock market train wreck before it happens. With this knowledge, they believe, they can move their portfolio to cash and sidestep the turmoil that uninformed investors will inevitably face.
In other words, as their name implies, this type of investor is in the business of predictions. Quite simply, they make decisions based on their best guesses about how future events will unfold.
Although it may surprise readers who know me, the objective of this post is not to argue whether or not predicting the future consistently is possible.
Smart investors know that even the best forecasters get it wrong more than half the time, but that is a topic for another day.
Rather, my question today is whether or not the behavior of making decisions based on predictions is consistent with other aspects of our lives.
In other words, do we generally take on a mentality of prediction or preparation in situations of uncertainty?
I would argue that in most instances where the future is unknown, human beings seek to prepare themselves for the uncertainty of the future by managing risks, as opposed to trying to predict the outcomes and then placing their bet.
Below are a few real-life examples that hopefully illustrate this point:
Do you make a prediction before you get in a car about whether or not you will get in an accident that day? Does that prediction determine whether or not you decide to wear your seat belt during the ride? I sure hope not!
Instead, because the inconvenience of wearing a seat belt is clearly outweighed by the protection it offers, we buckle up every time so that we are prepared in the event of an accident.
The consequences of a bad crash are simply too high to leave such an event to chance.
Do you cancel your insurance policies during months you’re feeling safe and then reapply when you feel concerned about the safety of your family, your property, or your life? Of course not.
We purchase insurance and pay our premiums because we want to be prepared at all times if the unexpected happens.
We’re not willing to rely on our crystal ball when it comes to protecting our loved ones and our valuable assets.
When you look in your wallet, does it contain a single form of payment? For example, only one credit card or just cash? Doubtful.
More than likely, you carry some cash, a debit/ATM card, and a couple of credit cards. Whether you do it consciously or not, the reason you carry multiple forms of payment is so that you are prepared.
What if the store at all mall doesn’t take American Express? No problem I have my Visa.
What if the restaurant doesn’t take credit cards? No big deal. I’ve got cash.
Instead of trying to predict what your day is going to look like and then carrying only the forms of payment you think you’ll use that day in your wallet, you prepare for anything by keeping your wallet well-stocked.
For good measure, here is a short list of other life situations in which we are preparers (as opposed to predictors):
– Dressing in layers when hiking
– Keeping an emergency kit in your house and car
– Carrying a spare tire in the car
– Bringing extra batteries for the flash light on the camping trip
– Buying extra food for the party in case more people come
– Keeping back-up copies of important documents separate from the original
– Giving the neighbor an extra key in case you get locked out
What does this mean for investors?
As I said previously, the objective of this post is to think about how we deal with uncertainty in life and how that relates to investing.
Although the world will always be filled with predictions and forecasts, in many areas of our lives, we focus instead on preparation.
I would argue that investors would be well-served by taking a similar approach.
Instead of trying to predict what will happen in the market or whether interest rates are going to increase next year, you should develop a plan that incorporates a wide range of possible outcomes.
Such a plan should recognize that a 30% decline in the value of the stock market is well within the range of possible things that could happen.
Accordingly, as an investor, you should prepare by building a portfolio that is consistent with your willingness, ability, and need to take risk, but only take as much risk as you absolutely need to.
Likewise, it’s very possible that a single country could experience a protracted economic decline that would devastate investors whose entire portfolio consists of that country’s stocks.
For that reason, it is wise to prepare for that uncertainty by diversifying your portfolio around the world in both developed and emerging markets.
I could give a long list of examples, but the point is this:
As an investor, there are many things you can control and you would be wise to focus your attention on them.
For everything else, you should be aware of the likely outcome, the downside case, and the upside case. However, instead of placing your bets on one or the other, you should have a plan in place so you are well-prepared no matter what happens.