Preparation Without Guessing – A Wealth of Common Sense

A reader asks:

If you can’t see it coming, how do you plan for it?

This question was the answer to me 10 rules for dealing with uncertainty.

I liked the movie the rest. What can I say? I’m a sucker for coming-of-age movies.

Paul Giamatti plays a history teacher at an all-boys prep school. While Giamatti was explaining the importance of studying history to one of his students, this sentence came to my mind:

History is not just the study of the past. This is a description of the present tense.

After reading a lot of history, what I have read about the past is that the future is unpredictable.

One of my favorite examples of this is this memo from Pentagon employee Lin Wells to George W. Bush: Predicting the Future.

Wells described each major shift in geopolitics in terms of decades-long periods dating back to the beginning of the 20th century. Here is part of the text:

If you were a security policy maker in the world’s greatest power in 1900, you would be an Englishman looking warily at your centuries-old enemy, France.

By 1910 you would be allied with France and your enemy would be Germany.

By 1920, World War I would have been fought and won, and you would enter into a naval arms race with your former allies, the United States and Japan.

By 1930, there were limits on naval weapons, the Great Depression was looming, and the defense planning standard stated “no war for ten years.”

Nine years later, World War II began.

By 1950, Britain was no longer the world’s greatest power, the Atomic Age had begun, and a “police operation” was underway in Korea.

The declaration continued as follows until its conclusion:

All this means: I’m not sure what 2010 will look like, but I’m sure it won’t be what we expected, so we need to plan accordingly.

This letter was sent in April 2001, just months before the September 11 terrorist attacks. The decade of the 2000s included two wars, a major housing market crash, and the biggest financial crisis since the Great Depression.

No one could have predicted these consequences.

As important as it is to study history to understand the present, you don’t have to go that far back to understand this idea. The 2020s have already been as unpredictable as ever.

In November 2019, The Economist produced a cover story with experts predicting what might happen in 2020:

Their list of predictions includes a contentious Presidential election, Brexit, low/negative interest rates, US-China relations, etc. It contained things.

Guess what wasn’t there?

A pandemic that would shut down the world, causing governments around the world to unplug the economy, then plug it back in, sending trillions of dollars to citizens and businesses.

How can you guess this?

Here are some other things no one saw coming in the 2020s:

• Oil prices are turning negative.
• Supply chain shocks.
• The fastest stock market crash and recovery in history.
• The strongest labor market in a generation.
• 9% inflation that will not lead to recession.
• AI saved the economy with the launch of ChatGPT just as inflation was reaching its peak.
• Tariff Rage after Independence Day.

I could go on. None of it was predictable. If you try to build a portfolio by predicting events like this, it would be crazy.

So what is the solution?

How do you plan for these things if you can’t predict them in advance?

Some thoughts:

You accept uncertainty as the starting point. Admitting that you don’t know how the future will unfold is liberating in some ways. It allows you to focus more of your time on what really matters.

You set the expectations. A good plan requires basic expectations with the understanding that outliers exist. But you have to understand the difference between the things that happen. it could be It happens and things that usually happen. A good plan takes into account everything that is likely, not everything that is possible.

You include a wide range of outcomes in your plan. I expect to see bull markets, bear markets, booms, recessions, booms, busts, high rates, low rates, high inflation, low inflation, financial crises, and more. But I have no idea when these environments will occur, how long they will last, or the size of the moves.

You plan for these events to happen, but you have no control over when or why they will happen. And the timing of these events is impossible.

You create a plan based on rules. Automating good decisions in advance eliminates the need to guess what the next step will be.

You focus on what you control. You have no control over the future, what politicians will do, geopolitical events, the economic cycle, or the timing of bull/bear markets. You control your risk profile, time horizon, asset allocation, investment spending, and reaction to the events of the day.

You expand your time horizon. Unexpected events may have an impact in the short term but tend to improve in the long term.

You vary between scenarios. It’s impossible to diversify every risk, so you try to make your portfolio resilient enough to deal with different scenarios. This means diversification across asset classes, geography, market cap and strategy.

You make course corrections along the way. Financial plans are not fixed. You can update your plans as conditions change. You need to be flexible in an ever-changing world.

Bill Sweet joins me on the show again this week to answer this question from Ask the Compound:

We also discussed questions about in-plan Roth conversions, how box-based ETFs work, using a 529 plan for education later in life, and how much is too much for private illiquid investments.

Further Reading:
Why History Always Gets Things Wrong