Making Decisions Amidst Uncertainty Part III
This is the third and final part of a thought process around decision making amidst uncertainty. Last monthās letter explored the idea of ergodicity. The point was to recognize situations which are ergodic vs.
nonergodic ā ergodic situations being those where a single person can expect their returns to match the average return for an entire population. Nonergodic situations are those where a āgame overā outcome is possible and a personās early losses may eliminate their ability to realize future gains. This idea applies to sports competitions, investing, career development and many other areas of life.
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So how do we apply this information to decision making? One way is to only take risk to an extent that you can still accomplish your goals if things donāt go as planned. An example could be a competitive athlete in a multi-heat tournament. Should they try and go āall outā every single round to come in first place? Itās a risky choice.
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If the athlete tries for first place in every heat by giving 100% and takes unnecessary risks to win, they increase their risk of injury. If they get injured, they will be unable to compete in the finals and experience a āgame overā for the tournament. Instead, the goal should not be to win every round. Instead, they should aim to place anywhere within the group that still allows them to advance to the next round. This strategy
lets them keep energy in reserve and reduces their likelihood of injury in the early rounds. They are more likely to reach the finals where they can then give 100% to win.
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A parallel for investors could be trying to achieve above-average returns every year. This might be considered outperforming the index or reaching some other above-average
benchmark each year. Such a strategy would require above-average risk taking. The problem is it exposes that investor to above-average downside risk as well. If one year of above-average losses are sufficiently bad, that investor may lose so much that their portfolio cannot recover and theyāll run out of money entirely (game over). In that case, it didnāt matter how well they performed earlier in their series of returns. Their losses ate up their future potential gains.
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Instead, investors have the option of structuring their portfolio such that they keep the money they know will be spent in the near future in safer investments (like bonds). Once this bond portfolio is built and sufficiently funded, they can then take higher risks with the excess money in their portfolio. This ensures that, no matter what the losses in their riskier
portfolio, they never experience losses so great that they cannot recover.
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This is the concept at the heart of the Critical Path approach I employ for clients. Ā The goal is to only take risk with money that does not need to spent in the next 10 ā 15 years to allow sufficient time for recovery from losses in the short term. Additionally,
even the risks that we do take are not concentrated risks that could lead to unpredictable, above-average losses. Anytime you face a nonergodic situation (which is most situations in life) you want to proceed in a way that avoids the possibility of a game over. This is one way you can increase your likelihood of enjoying the lifestyle you planned on for your entire life.Ā
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Thank you for your trust and your time.
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Sincerely,Ā
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Adam Broughton, CFPĀ®, CPWAĀ®