Op-Ed: Since you can't beat the market, the key is to only take the risk you can handle
I tweeted this on May 15, 2013: "More news on coronavirus. I think this is our next black swan."
Now, seven years later, I'm sadly proven right. Why did I say this and how did I know? How did it change what I recommend people do about their financial well-being?
Many financial careers are built on predicting the future. If someone makes a lucky guess and gets the timing right, they become famous and people pay incredible sums to hear their prognostications. A booming stock market whips people into a frenzy and they go all in to make as much money as possible.
Sometimes the wrong people get sucked into the hysteria, specifically, those who need to use their money such as retirees. In their zeal for high returns, they take on too much risk. When a crash occurs, they do not have the financial resiliency to withstand the pain and incur significant losses to get the cash they need to pay bills.
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The coronavirus and the stock market are good examples of "complex adaptive systems" – we can't predict how small events can throw the entire system out of whack. People think they can predict the future, but they don't know what they don't know.
The coronavirus has been around a long time – it is a cause of the common cold. However, there were a few coronavirus cases in the Middle East in 2012 that resulted in a serious pneumonia and a high death rate, just like we are seeing now. These were the cases I tweeted about.
But that strain of coronavirus was not very infective, meaning it was difficult for one person to spread it to another. Many of us realized it would take just a tiny mutation to allow aerosolized transmission and with a slight sneeze, we would have a pandemic on our hands. And here we are.
For predictions to be worthwhile, the prognosticator also has to get the timing right. And therein lies the problem. I had no idea when the coronavirus would mutate. Likewise, we all know markets go up and down, but no one consistently knows when crucial events will occur.
You may get lucky on when to sell, but when do you get back in? After the 2008 downturn, many missed years of earnings when the tide turned in 2009.
What is an investor to do? Instead of trying to beat or time the market, the key is to only take the amount of risk you can afford to take financially and psychologically. There are four important principles to follow.
First, figure out how much money you require for your expenses and create a financial plan to understand what is needed for financial independence. This involves breaking down your "needs" – the cost of housing, food, transportation, and health care — and your "wants," such as toys, entertainment, unnecessary clothing and any other expenditure not needed to live.
People who plan on working at least five more years should fund a money market account to cover at least six months of required expenditures. People in retirement or within five years of retirement should have at least 10 years of cash flow covered by Social Security, pensions and conservative investments such as bonds and money market accounts.
No one knows what the future holds, but by living life fully and reducing complexity, we can more easily face the upheavals that occur.Carolyn McClanahandirector of financial planning at Life Planning Partners
Next, create an "investment policy" you will stick with no matter what the stock market is doing. This determines what percent of your money will be allocated to risky investments, such as stocks, and to conservative investments such as bonds. An allocation of at least 50% bonds is often more appropriate for those starting retirement.
When the stock market is doing great, it is important to rebalance your account to sell the winners and buy more bonds. Likewise, when the stock market crashes, as painful as it seems, it is important to rebalance again – sell your bonds and buy into stocks. Having an investment policy to guide you takes the emotion out of making investment decisions.
Third, put in the building blocks to create resiliency for whatever life throws your way. Carry the appropriate disability and life insurance. Prepare your estate plan so your family can take over if you become incapacitated or have an untimely death. Take care of your health to reduce potential medical expenses and to live a better life in general.
Finally, simplify life and live fully in the present. No one knows what the future holds, but by living life fully and reducing complexity, we can more easily face the upheavals that occur.
— By Carolyn McClanahan, certified financial planner, M.D. and director of financial planning at Life Planning Partners
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