I don’t have all the answers.
What I do have is a way of thinking. A framework from which decisions can be made and questions can be answered. I have my investment principles.
These are the Principles of Perpetual Prudence.
Anything that goes against these principles can be safely discarded. If something doesn’t fit with the principles, it’s ignored. It’s that simple. Anything that initially fits with these principles deserves further investigation.
“Life is short!”
No, it’s not. It’s literally the longest thing you will ever do. Life is a reaaaally long game. Anything that you do over your lifetime is also a long game. This includes the act of lifetime wealth accumulation, which is achieved via lifetime investing. So, when we think about lifetime investing, we must think long-term.
Having a long-term frame has several beneficial second-order effects too, such as:
- Compounding. We’ve all been told 1000 times how important compounding is (I’ll spare you the Einstein quote). Everyone has seen the charts. However, I still don’t think people truly appreciate its power (we are generally bad at comprehending the non-linear). The multiplicative dynamics of compounding can only be fully captured in the long-term. The longer your term, the more you will get to enjoy these dynamics and at an increasing rate. This is the true power of compounding. It can only be truly realised in the long-term.
- Psychology. Having a long-term lens acts as a psychological buffer. If you think about your whole lifetime as your investment horizon, yearly fluctuations really do become meaningless. I know, I know – easier said than done. But having this view is the first step to avoiding costly psychological mistakes in the short run. Having a long-term frame helps you to be a calmer investor.
- Others. There are other benefits too. I won’t bore you by listing them all. There are also those which we can’t comprehend or understand. It’s a powerful way of thinking. Very powerful.
The real risk in holding a portfolio is that it might not provide its owner, either during the interim or at some terminal date or both, with the cash he requires to make essential outlaysRobert Jeffrey
I find this to be an adequate definition of risk for our purposes (1). How might your money not be there when you need it? 2 ways. Firstly, financial assets fluctuate in real value – fluctuation risk. Secondly, the value of financial assets can go to 0 – bankruptcy risk.
All financial assets experience both these types of risk. Financial markets are complex, dynamic, unpredictable, unforecastable, adaptive systems. They can, and will, be downright cruel and impossibly unfair. You must proceed with caution.
This is made worse by the fact that lifetime investing is a high-stakes game. One of the highest you can play. If you fuck it up, your life savings are at risk. All that cash you’ve spent accumulating and investing can go up in flames. All because you got over-excited about a new cryptocurrency or saw the returns of a hot, new fund and thought “I need to get a piece of this action!” Sigh. That is exactly how you lose your life savings.
Lifetime investing is about long-term risk management (2). It’s how you ensure you don’t lose at this high-stakes game (and not losing is vastly more important than “winning” here, whatever “winning” is…).
Losses hurt more than gains. This is the case both psychologically and mathematically (3). This can be illustrated with a very simple example. Start with a portfolio with value £100,000 that loses 10% one year followed by gaining 10% the next year:
You have lost a substantial sum seemingly purely via fluctuations in your portfolio value. Doesn’t seem fair at all. This is known as volatility-drag. It can even have a dominating effect in favourable games as Ollie Peters showed in his paper The ergodicity problem in economics. This is because the system (like many systems in the modern world) is non-ergodic. The expectation over time (what you get when you play the game over a long period of time) is different from the expectation over space (what many theoretical yous get when the yous play the game over some fixed time period). Crumbs.
You must try and avoid losses by limiting your downside.
Although I have my doubts about whether financial markets have entirely stable statistical properties, it is obvious that financial markets have fat tails.
What this means is that most of the observations will be inconsequential and, occasionally, you will see huuuuge swings in price. For example, as has been shown on the Motley Fool, if you were investing in the S&P 500 from 1999 to 2018 but missed the 20 best days your annualised return would be -0.33% as opposed to 5.62% if you stayed fully invested. Most of the gains come from a small portion of days (with the gap widened by compounding effects). Similarly, most of the losses come from a small portion of days. This is the result of fat tails.
These huge swings can damage your portfolio value. That can hurt. Really hurt. You can avoid these big losses by constructing your portfolio in such a way as to try and limit your downside (4).
Details are important. A small difference in return or charges or taxes can make a significant difference when compounded over the long-term (we have seen all of those charts, too).
However, details don’t mean shit if your portfolio crashes in value just before you planned to make a big withdrawal. Getting an extra 0.5% out on your savings is cool but irrelevant if you have the wrong lifetime investment strategy.
Worrying about the details without the right big-picture strategy in place is like worrying about getting sunburnt on the beach when a tsunami is coming. Fuck the suncream – get to a very tall building. Fuck tax-efficiency/low fees/savings rates, make sure you have the right long-term plan in place, otherwise you will drown. If you neglect your overarching strategy, you will ultimately fail, regardless of the details.
(1) Some like to differentiate between risk and uncertainty, defining risk as known in advance and calculable (usually expressible as a number/probability) and uncertainty when the level of known risk is unknown. For our purposes, uncertainty is incorporated into risk as it can affect both fluctuation risk and bankruptcy risk. Because of this incorporation, risk will be not be as ascertainable as it may first appear.
(2) Not to be confused with Long Term Capital Management. Definitely not the way to do lifetime investing.
(3) Maybe the former is true because the latter is true…
(4) This may not always be possible in the context of retail investing. Often this can require the use of derivatives which 99.999999% of retail investors should not be considering under any circumstances. I still think it’s good to have the desire to limit downsides regardless of your at-times limited ability to do so.