You never know what you are going to get.
Most of us understand what a 1% chance of a flood happening over a one-year period means. We recognize it is highly unlikely to happen.
Our understanding can become a bit murkier when we add additional variables and years to the situation. For example, what are the chances of this same flood happening over a 100-year period? The likelihood goes up quite a bit. It is more likely than not—63.4%—that there will be a flood within the next 100 years, even though the one-year probability is just 1%.
As investors, macro events can have a direct and dramatic impact on our portfolio. We need to understand that “bad” things can and do happen.
Let’s start with a very short list of some possible bad events:
- Terrorist attack
- Sovereign-debt default
- Pandemic
- Major war
If we put just a 1% probability on each of these independent events happening in any given year, over a person’s lifetime—say 80 years—there is a near-certain probability of 95.9% that any one of these bad events will happen. Now imagine if we add just a few more possible events to this list: global recessions, social unrest, minor wars, assassinations, inflation, and so on. You can see where this is going: bad things happen.
The future is uncertain and we should assume a lot of bad events are going to happen, so it is important to accept this fact—the fact that we are never going to know what we are going to get.
I would add that even with all the bad things that will happen in the future, more good things will actually happen. Just look at how far we have come from our cave-dwelling days. As Warren Buffett has said more than once, “Our best days lie ahead.”
Most of us would agree that a carefully constructed investment portfolio can weather a lot of bad economic storms. None can withstand the fatal blow of an investor who panic-sells or invests in things they do not understand.
I like the idea from Morgan Housel: “Save like a pessimist, invest like an optimist.”
-Paul R. Rossi, CFA