Slam Dunk Financial Planning
I don’t watch many live sports these days. Life is busy. But I’ve caught a few quarters of NBA playoff basketball, and I’ll watch game replays while sipping morning coffee.
If you’re unaware, the NBA has been revolutionized by “Moneyball” ideas over the past decade. The main “new idea” affects 3-point shots. The ratio of attempted 3-point shots has increased dramatically in recent years.
Yet, despite the league’s new widespread emphasis on 3-point shots, one basketball maxim remains true: a wide-open layup or slam dunk is always worth taking. A guaranteed 2 points is better than a possible 3 points.
Reducing your range of outcomes has many benefits. In this particular basketball scenario, simple math supports it; 99% of 2 points (a near-guaranteed dunk) is better than ~40% of 3 points (the approximate make percentage of 3-point shots).
There are ancillary benefits, too. A reduced range of outcomes is simply more dependable and, thus, easier to plan for.
Smart financial planning reduces the range of outcomes in your life, specifically by decreasing the odds of financial failure. The more I study successful financial plans, the more true this idea becomes. A good financial plan will:
- Identify possible failure mechanisms (i.e. risks) and abate them.
- Provide options for short- and long-term flexibility (e.g. ways to go around future obstacles)
- Increase the probability you reach your unique goals (even if decreasing the odds that you die filthy rich)
Devil’s Advocate: What I Don’t Mean
I think the devil’s advocate would read those words and say:
“Jesse – just buy a 30-year bond. Guaranteed 4.6% rate! There’s your outcome. No variance to it whatsoever.”
Or perhaps worse…
“Jesse – buy a indexed life annuity. Wait 10 years, then start collecting your guaranteed 4% annual returns for life. No variance!”
It’s true. Both investment ideas have a singular range of outcomes. And I just touted that as a good thing. But, to be clear, I believe those specific outcomes are pretty bad. Long-duration bonds expose us to a terrible amount of inflation risk. Annuities are almost always a complete racket.
I’m not seeking guarantees at any cost. I want to be very wary of the costs.
Some Examples…
What exactly do I mean?
Life insurance protects against catastrophic failure mechanisms (that you die and leave your family’s finances in lurch). I want to eradicate that outcome. Blow it off the map. While whole life insurance (and similar ideas) are frequently atrocious products, a good term life policy is essential if loved ones depend on your income.
A diversified portfolio is another way to narrow the range of potential outcomes. It will always underperform some of its constituent parts and always outperform others. Quilt Charts (like the one below) are wonderfully illustrative.
Look at that white “EW” box, which stands for an Equal Weighted portfolio of all the asset classes. EW never wins. But it never loses. It does reduce the range of outcomes, providing a “reliable” level of investment returns. It provides an expectation – a foundation – from which you can build a sturdy financial plan.
But Jesse! Stocks outperform bonds over the long run!
Yes, it’s true. On average, stocks do outperform bonds. But an important adage in financial planning is to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.”
Or put another way: a long-term average can gloss over nasty short-term blips. Just look at the chart below. Who would look at that and choose a 60/40 or 40/60 portfolio over a 100% S&P 500 portfolio? It doesn’t make sense!
However, as I described in this article, the short-term volatility of stocks can cause our human wiring to short-circuit. When applied to portfolio management, that simple human fallacy is one of Danny Kahneman’s most prolific ideas.
Another way to reduce your range of outcomes is to give yourself more time. Perhaps my favorite Jack Bogle quote is that “reversion to the mean is the iron law of Investing.” The only way to experience that reversion to the mean is to buy and hold a stable allocation of assets for a long period of time.
My favorite illustration of this idea is below. The full explanation of this chart is in this older post.
- We’ve seen 10-year periods where the S&P has returned more than 20% per year (the beginning of the black line).
- We’ve also seen 10-year periods of decidedly negative S&P returns (the red line). That’s a wide range of outcomes! Booo!
- But over 30-year periods, we see an amazing reversion to the mean. Everything ends up in the 5-8% range (PS – these are all inflation-adjusted returns).
Simply put: time allows us to reduce our range of outcomes.
Personally, I think humility and contentedness are beneficial too. A good Retirement plan would lead a retiree to say:
- There’s a 60% chance I live the exact Lifestyle I want to in retirement.
- There’s a 30% chance my lifestyle is slightly better than I expected.
- There’s a 10% chance my lifestyle is slightly worse than I expected.
- But no matter what, all three scenarios are acceptable to me, so there’s a 100% chance I’ll enjoy life throughout my retirement.
That is a reasonable range of outcomes. It takes humility and contentedness to accept that. Imagine I took the scenario above and poured some gas on the portfolio, such that the retiree said:
- There’s a 60% chance I live the exact lifestyle I want to in retirement.
- There’s a 30% chance my lifestyle is WAY better than I expected.
- There’s a 10% chance my lifestyle is WAY worse than I expected.
Would you pursue “WAY better” at the risk of “WAY worse?” Do you need to take that risk? To each their own, but I posit “no way, Jose!” I don’t want to intentionally widen my range of outcomes in that way.
Why risk a lifestyle that is perfectly tolerable for one that is intolerable? As Uncle Warren says about taking unnecessary risk, “Why risk something you have and need for something you don’t have and don’t need?”
If you can build a reasonable expectation of long-term returns (that is, a narrow range of investment outcomes), you can design a specific future state. You can plan to spend, save, gift, grow, etc. in a precise way. That sounds pretty good to me.
Flexibility helps too. Retirement rules like the 4% rule improve immensely if used flexibly. Specifically, I mean if the retiree in question is willing to decrease their spending in down markets. A little bit of retirement flexibility opens up doors to spending more overall.
Starting early is another key to reducing your range of outcomes. Simply put, it’s harder to fail when you and your dollars are working for a longer period of time. Getting your ducks in a row at age 32 is infinitely better than age 62.
Buzzer Beater
I want your personal finances to be high-scoring, don’t get me wrong.
But I don’t want stomach-churning uncertainty. I want dependability.
I want an easy slam dunk.
Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
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