If you are like most of us, feelings of uncertainty can bring on acute discomfort. We do our best to avoid it. Did you know that in research studies where people receive electrical shocks, participants show greater stress in situations where there is a 50% chance of receiving a shock rather than in situations where there is a 100% certainty that they will receive a shock.
What’s going on? Surely, we’d always welcome “fewer shocks”?
Neuroscientists have tracked the brain activity behind this kind of flawed decision-making and it appears that there is heightened activity in the amygdala, which results in a hyper-vigilant state during periods of uncertainty. From an evolutionary perspective, it made sense for the brain to increase the chances of physical survival during very uncertain and dangerous times.
Of course, the investment world is inherently uncertain
As a result, it’s helpful to think about mechanisms and attitudes that could increase our probabilities of long-term investment and financial planning success. It’s also important to note the perception of uncertainty varies greatly from person to person. Our personal experiences and belief systems shape our attitude and reaction to the world around us.
If we go out of our way to avoid uncertainty, how can we succeed at investing?
It’s important to accept that some uncertainty will always be unavoidable, even with the most conservative of investments. Risks are not always obvious – for example, there is usually inflation risk associated with predictable interest-bearing investments such as a Money Market. A higher rate of investment return over the longer term can be viewed as the reward for living with the risk and uncertainty that many people just can’t stomach.
Be honest with yourself
Self-knowledge is important. An overly aggressive investment strategy with high levels of uncertainty is unlikely to work long term if you cannot pass the sleep test when things don’t go your way (and they might not go your way for an uncomfortably long period of time). It could be more sensible to moderate your retirement financial goals, and choose to have a more balanced and predictable portfolio.
Forewarned is forearmed
Historical measures of risk and return can provide an indication, but never a guarantee, of what can be reasonably expected from your investment portfolio. If you understand the unpleasant short-term experiences that you may have to face in advance, then you will be better equipped to deal with the situation if and when it happens.
Diversification staves off disappointment
Investment diversification is a key strategy to reduce overall portfolio risk. There are various ways to diversify: across asset classes (e.g., shares and bonds), asset managers, geographical regions and currencies.
Any well-designed investment portfolio should be able to mitigate against uncertainty to some extent. For example, withdrawals can be sourced from the stable parts of an overall portfolio, thereby avoiding selling volatile growth assets at an inopportune time and locking in losses.
Resist the urge to peek!
As difficult as it might be, avoid the temptation to look at your investment values too often. Short-term market movements can be influenced by investor emotion, incomplete information and randomness. Even quarterly assessments have the potential to lead to poor decision-making.
By Richard Sparg, CFP® CA(SA)
