Let’s face it. One reason that economists and financial advisors are sometimes caricatured as not knowing anything is because, well, there IS a lot that we don’t know - in fact, that we can’t possibly know in advance. When planning for our financial futures, we are forced to operate in the world of possibilities and probabilities, whether we’re looking out 40 years – or 365 days.
So how should investors handle this uncertainty?
First, in financial planning, probability analysis can help us understand what a “worst case” scenario probably looks like. In our planning, we use what statisticians call a “Monte Carlo simulation” to help us determine the likelihood of running out of money during retirement. These projections help us keep retirement spending in check so clients get a satisfactory answer to the question, “Do I have enough?”
Second, in market and economic forecasting, we use back-tested models to look for indications about what is most likely to happen in the future. In 2009, May-Investments developed its own proprietary Leading Economic Index to help us anticipate where the economy is headed. For the past four years, this indicator has correctly projected that economic growth would continue. While it can’t be relied upon to be 100 percent accurate, at least the indicator gives us a sense of what is the more likely outlook going into 2013.
Finally, in stock-picking, we look for asymmetrical return distributions in the stocks purchased in the portfolio. We like to own stocks with the potential for growth in the Price/Earnings ratio that the market applies to the stock. A company that normally sells for 15-times earnings, if purchased at 10X, has room for 50 percent upside even if earnings stay flat, if only the stock valuation returns to normal.
Ideally, portfolio companies are experiencing upside earnings growth and also have room for P/E expansion. By buying stocks with steady earnings growth and relatively low valuations, we should be able to reduce the likelihood of a major decline in the stock price while preserving the potential for significant upside potential. Or, in English, we are hoping to find stocks with a better chance of going up a lot, even if it means taking a chance that they go down a little.
We don’t want a normal bell-shaped curve where upside and downside are evenly distributed. We prefer the added protection that accrues to investors who purchase shares at a discount to intrinsic value. Although we can’t actually know ahead of time how the stocks will perform, we can reduce the amount of risk we’re taking by focusing on good companies whose valuations are already depressed.
Investing and financial planning are long run endeavors. Only after a series of decisions are made and subjected to the fickle fortunes of chance will the solid plans stand out. In the short run, luck distorts the results. In the long run, however, diligent planning pays off. In fact, having a financial plan is the primary determinant of whether or not people are satisfied in retirement. And although I’d rather be “lucky” than smart, wisdom suggests that prudent planning helps people take advantage of good fortune and can protect them against misfortune. More than likely, it is discipline rather than luck that separates winners from losers in the long run.
Our disciplines suggest that economic growth will continue into 2013. The stock market could have another pretty good year. The political grandstanding demonstrated by our so-called leaders did more to hurt the economy at the end of 2012 than it will to depress spending in 2013. Maintaining a 4% to 5% withdrawal rate will likely work for most people, unless they are overinvested in cash equivalents and bonds. Updating your financial plan will help you keep your spending to a reasonable level.
Will these disciplines work for you as well as they’ve worked for us? I have no idea. If we did know, exactly and precisely with crystal ball clarity, we could certainly make more money for clients and ourselves by operating using a lot more financial leverage. But where do we get one of those crystal balls? That’s the problem. I dunno.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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