Much of the disconnect between people's behavior and the principles of sound planning comes down to this distinction:
- Deterministic: Following pre-defined rules, where inputs are causal and lead to predictable, calculable outcomes.
- Probabilistic: Predictions can be made about the likelihood of uncertain outcomes, but the uncertainty remains.
I think most people intuitively understand, if asked, that financial outcomes fall pretty firmly in line with the second version. Most people know by now that the stock market does not follow predictable patterns. Jobs, salaries, clients, economic cycles, technology shifts, business outcomes, and critical health outcomes don't exactly fall out of the sky in pure randomness, but we all know that we don't pump answers into a system and get out exactly the result we wanted and expected all along. There's chance involved. Some probabilities may be predictable on the whole, but each exact outcome is not.
And yet, when people start focusing on their own financial expectations, strategies, and plans, they have a tendency to expect the first version. Deterministic. They want to know, simply, if I do "X" what "Y" will I get? Or, if I want "Y" what "X" do I need to put in, exactly?
This also makes sense, and there are a few good reasons for this:
- Emotion: Financial outcomes are, generally, very important, and it can be scary for many to accept anything but complete control over outcomes. Seeking predictability and control is normal.
- Tradition: In fairness, the industry hasn't always done a great job of dissuading people from expecting determinism. Many have been taught that retirement planning, for example, is about putting numbers into a spreadsheet, calculating the result, and (implicitly) knowing what you will get. It's not clear that everyone understands that a market index, for example, doesn't deterministically produce a specific rate of return because it must, but rather it has just tended to do so in a certain number of cases, and is always subject to change.
- Numbers: Our intuition about numbers is also perfectly understandable. It's natural to feel like there must be some obvious, indisputable outcome, because math is often deterministic. Some of the best examples of deterministic systems, in fact, are math and math-adjacent. 2+2 must equal 4, computer code does (generally) determine predictable outputs. Why wouldn't we be able to enter numbers and simply find out what the answer will be? It's deeply tempting.
...but it isn't that way. In most of the important ways, your financial life will be determined probabilistically, and not deterministically. You will not know what dice roll you get in advance on any number of key factors that predict your financial outcomes.
Is this depressing? Should we just throw up our hands, or try to get to know the probabilities and hope for good luck? Fortunately, no.
So what can we do about this?
The keys to sound financial strategy all boil down to this. Instead of feeling the need to determine what will happen, determine what can happen and understand what you will do if and when it does.
- Buckets: Segment your strategies so that you have a predetermined tool to use in good, bad, mixed, and complicated times.
- Diversification: Most people know this on paper, but it's very hard to believe and put it into practice consistently. It's easy to have a short memory, and to forget why you have the backup dragging you down when the primary seems to be functioning just fine. But you often need the backup, sooner or later.
- Correlation: In conjunction with the above, one of the hardest things about diversifying successfully is to identify and understand correlation. Extending the "backup" analogy, if two backup generators are located in the same place and equally exposed to storm damage, it's possible to lose not just main power but also both backups due to a single cause (eg, a storm). They need to be as isolated as they can be, and real-life separation in financial markets can be fairly difficult to identify and implement.
- Risk-transfer: One thing about probability is that there are many sorts of outcomes that you might feel pretty sure won't happen, but if they did, they'd be absolutely catastrophic. Depending on the outcome and your exact situation, you may not be able to recover if you did get the unlucky dice roll. In these situations, it might make sense to share or transfer the risk to a group or institution that can withstand those rare outcomes, because of scale.
- Don't Forget Probability: It's true that there's a big difference between "likely" and "certain", but that doesn't mean we resort to chaos. You don't need to commit 100% of your resources to preparing for a low probability event. We can size our protections, contingencies, and backup plans appropriately based on (1) the likelihood that they may occur and (2) the magnitude of the impact if they did. This is actually a more helpful tool than it first seems. It answers a lot of questions. For example, if you fear a market downturn (it can happen!), do you sell everything and hide the money under the mattress? More likely, it makes sense to determine how you need to be positioned to accomplish your wants and goals, while shielding yourself from any intolerable impact. Each decision should be case-specific to what's going on in your life, specifically, but the same principles and processes apply in making that determination.
The first step is to understand the difference between what must happen because of the laws of the universe, and what may or may not happen, despite how much we want or expect them.
Once we come to terms with that, it's much easier to determine and implement strategies to dictate what we will be able to do if and when the likely, or unlikely, outcomes emerge in our reality.
2025-7716021.1 Exp 03/27