The state of financial literacy in our country is in poor condition -- very poor condition. So when the average American sits down with a financial advisor, and that financial advisor plugs in investment returns based on the market's historical average, we don't think twice.
That's a huge mistake, according to Nassim Nicholas Taleb -- a former trader, current best-selling author, and distinguished professor of risk engineering at NYU's Tandon School of Engineering. Recently, I sat down with Taleb to talk about how we should be considering stock returns when we put together our own financial plans.
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On automatically assuming you'll get the market's historical annual return of 9.2% per year
It's not hard to find third-party evidence to back up this assertion. Foolish colleague Matthew Frankel -- using data from Dalbar's Quantitative Analysis of Investor Behavior -- showed, in 2015, the average investor's returns were terrible.
This happens for lots of reasons. Frankel cites the herding behavior of buying high and selling low as a key culprit. Indeed, it's easy to say you'll be greedy when others are fearful -- and visa versa -- but difficult to actually do it.
On "uncle" points and forced liquidation
In his other writings, Taleb throws in other examples of "uncle" points, like an unexpected divorce, health problems, and the like. The point is simple: You are more likely to liquidate your position -- whether out of fear or necessity -- when the market drops. This will ruin your returns.
How to deal with this reality
Unfortunately, many of the strategies that Taleb uses are sophisticated and difficult for the individual investor to enact.
Taleb argues that just keeping a lot of cash on the sidelines isn't necessarily the best strategy, either: "The risk of having a lot of cash is that if the market rallies -- for the individual investor it doesn't work well -- you have all this cash, you missed on a big move."
That leaves just one primary approach for individual investors, which I've already written about before: the barbell approach, or, "to have a smaller amount allocated to the most volatile things, rather than a larger amount allocated to medium-volatile things."
An alternative view
As a site primarily for individual investors, I was left wondering what to do about Taleb's justified fear of just holding cash. The phrase I kept coming back to was, "it allows you to buy when nobody has dry powder." Dry powder is the key -- it gives you options when [stuff] hits the fan. The most satisfying solution I could find was fleshed out by former Fool Morgan Housel a few years back.
Morgan wrote a number of interesting articles on this conundrum. In essence, it was about reserving a standard percent of your portfolio in cash -- but not too much -- and only deploying it when the market fell by a certain amount.
The key: protect your downside
One of the most fundamental tenets I've gained from Taleb's writing is that -- no matter how remote the possibilities seem -- you always need to be paranoid about protecting yourself against highly unlikely misfortunes.
If you're looking for the simplest solution to not having to liquidate when a crash occurs, here are a few very simple steps that will markedly improve your performance:
- Make sure you have sufficient insurance (health, vision, dental, disability, etc.) so that out-of-pocket expenses are capped at an amount you can cover in a moment's notice.
- Keep an emergency fund on hand that can provide for your family for three to six months without any form of income.
- Live below your means!
- Only check your portfolio quarterly -- or develop the stomach for big swings.
When you have this protection, your "uncle points" are far less likely to hit, and you could actually end up gaining from market downturns in the long run.
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