Big PictureInvestor PsychologySMSF Strategies

Understanding probability in investment

9 Sep 2021 1 month(s) ago

Sound investment means understanding risk and reward and managing your investments accordingly. There are many risks around risk taking -- the wealthy try to avoid it.

In an interview with this writer, a person on the BRW Rich List explained that one reason why he was so wealthy is that he understood risk and reward. The ordinary person, he said, thinks that a 50-50 bet is a good idea. He thought that to be a terrible option. If he was going to take a risk, he said, it would be at least a 90-10 bet, and even that was problematic. 

The myth is that rich poeple are risk takers. This rich person explaine that exactly the opposite is true. Rich people try to reduce risk as much as they can so they can be certain they will get even more money.

That principle is worth remembering, especially when it is realised that investment is necessarily a matter of managing probabilities in relation to the unknown. That is the insight of Professor Bob Merton, a Nobel Prize winner, professor of finance at the MIT Sloan School of Management and chief scientist at fund manager Dimensional. What matters is to focus on maximising the probability of achieving defined outcomes, usually achieving a specific cash flow result.

For an ordinary worker, the focus should be on having a reliable stream of cash flow in retirement as they move from accumulation to draw down for retirement. Whereas at the moment the debate and the discussion is around asset allocation. But if sequence risk hits, as it did in the global financial crisis, a policeman or a nurse or a road worker, who suddenly find out that they have got 30 or 40 % less of their savings than they had the previous month, was devastated psychologically. They were forced to work longer. They had to spend less, to save more, and perhaps borrow.

Merton argues that the focus should not be about asset allocation in itself, but on maximising the probability of having a defined revenue stream in retirement. Put another way, the concentration should not be on wealth, but on the income that is desired. The risk to be managed is the possibility that this ultimate income goal will not be realised.

So how is it possible to maximise the probability of the desired outcome? His solution is to sell some of the upside to give certainty of protecting the downside, which he called a dynamic-portfolio strategy. In this approach the focus is to cut out the excess upside possibilities – big bets to improve wealth -- to improve the chances of achieving the desired income target. If investors do not need to take the risk they should not be taking the risk.

Professor Michael Drew at Griffith University has conducted tests on different model portfolios looking at sequence risk and what tools might mitigate it: what happens if markets fall catastrophically. He showed that if someone is 70 years old and 90 % of their assets are sitting in growth securities they will never recover.

Merton argues that a plan provider should begin by asking employees not about risk but about their expectations for income needs in retirement. Employees in their twenties, thirties, or forties will not be able to be very specific but will likely agree that a reasonable goal is a standard of living similar to what they had been experiencing in the last phase of their working life before retirement.

Once the expectations have been agreed on, the provider can calculate the probabilities of achieving each employee’s target standard of living for given levels of contribution, expressed as a percentage of salary, and for a given working life. That allows the client to work how much needs to be contributed from current income, and how long it will be necessary to work.

Merton puts it this way:

“Suppose the saver learns that she has a 54% chance of achieving her desired income in retirement. Like a high cholesterol number, that relatively low probability serves as a warning. What can she do to improve her outlook? There are only three things: Save more, work longer, or take more risk. These are, therefore, the only decisions a saver needs to think about in the context of retirement. And those choices have immediate impact because if you increase savings, your take-home pay check is going to be smaller. If you decide to retire at a later age, you will have to explain that decision to your family and loved ones.”



Reader note: This is general reporting only and should not be considered in any way to be investment or tax advice. It does not take into consideration the investment objectives, financial situation or particular needs of any particular investor. For more information please read our disclosure statement.

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