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Protecting against risk that cannot be quantified.
Donald Rumsfeld famously described two forms of danger. The common variety, against which one plans, involves “known unknowns.” However, said Rumsfeld, the real concern is the unanticipated hazard of “unknown unknowns.”
Although offered as geopolitical advice, Rumsfeld’s guidance very much applies to investing. Traditional investment research addresses known unknowns. Security returns are the unknowns. How Tesla will perform tomorrow, or over any other period, is guesswork. (For example, who would have predicted that the company’s shares would have gained 85% since my early January column, “Tesla: A Stock for Our Times”?) To attempt otherwise is to invoke a Dark Art.
In contrast, the knowns are relative returns, relative risks, and distribution ranges—how asset classes will likely behave over long time periods, under normal conditions. When I joined Morningstar in 1988, I was informed that stocks would outgain bonds, high-yield corporates would outdo intermediate-term Treasuries, and each asset class would exceed cash. All that has since occurred. The relative risks of stocks, junk bonds, Treasury notes, and cash have also matched my mentor’s expectations.
From such material is investment commentary made. Among equities, is there a “small-company premium” that rewards lesser-known businesses, or a “value premium” for lower-cost stocks? Will the shares of companies from emerging countries appreciate more than those from developed nations, to compensate for their greater risk, or will those theoretical profits be consumed by corruption? With fixed income, to what extent will long bonds outgain short notes?
The list continues, through the details of private-equity securities, such as venture capital, and then on to pooled investments. Mutual funds, exchange-traded funds, closed-end funds, hedge funds … each has its own advantages and disadvantages that merit further discussion, as does the decision to invest passively or actively.
These are the bones for the Chartered Financial Analyst’s curriculum. The aspiring investment researcher learns about the expected returns, risks, and features of the various asset classes; how they might be combined to form portfolios; and the different versions of funds. Combine all that information along with a client’s specific situation, such as time horizon, tax status, and investment goals, and conventional expertise is achieved. The CFA candidate becomes certified.
This is fine. The better that investment knowns are understood, the fewer investor surprises. Academics receive Nobel Prizes for illuminating such topics. On a humbler level, professional researchers write constantly about investment knowns. I am no exception. When preparing this article, I had planned to discuss whether the traditional balanced portfolio of 60% stocks/40% bonds was still suitable. However, Morningstar’s Lauren Solberg got there first, publishing an article that closely expressed my thoughts, so I took a different tack.
That being to address the unknown unknowns. They are best regarded as a form of “portfolio insurance.” By that term, I do not mean the ill-fated investment strategy of the 1980s, which attempted to protect against stock market declines by shorting futures contracts, then crashed into the rocks in October 1987. Instead, I refer to planning for outcomes that exceed the “normal conditions” upon which conventional analysis relies.
An example would be to trade a lifetime’s accumulation of stocks and bonds for real estate and gold bullion—as did a friend’s father. In his case, the customary belief that stocks would outgain inflation over the long run no longer applied, as he believed that the U.S. government was unlikely to fulfill its obligations. For that investor, the unknown unknown was neither an unimagined nor a remote possibility; it was an obvious and open likelihood.
That, to be sure, is an extreme case. Here is a more common situation. In 1994, in “Determining Withdrawal Rates Using Historical Data,” financial planner William Bengen derived the common rule of thumb for retiree withdrawal rates, which states that investors can safely spend 4% each year of the initial value of their retirement portfolios, adjusted for inflation. Bengen’s research was based entirely on assessing the known unknowns of historic U.S. investment returns. He did not consider unknown unknowns.
I intend no criticism. Such work is fine and good. The many subsequent articles that have dissected Bengen’s findings have operated similarly. (Among those efforts was one co-authored by yours truly, in “The State of Retirement Income: 2022.”) However, one could regard such debates as naively aggressive because they assume normal conditions that might not arrive. Those expectations rely on the investment experience of the United States over the past century. But the U.S. is only one country, and this past century but one of many.
For those guarding against unknown unknowns, there are two prescriptions. One is to be conservative. Just because an investment strategy has almost always succeeded through three generations of U.S. history does not mean that it will do so in the future. After all, many eminent economists did not believe that inflation and unemployment could be simultaneously high, until that unfortunate event occurred during the ‘70s.
The second defense is to hold much more than merely traditional stocks and bonds. Gold and property have already been mentioned. Other possibilities are commodities, alternative investment strategies, and, most notably, inflation-adjusted bonds. Inflation skeptics argue that holding only fixed-rate bonds is akin to playing the financial version of Russian roulette. Most retirement scenarios will end well, but if inflation truly does not leave, then investment disaster awaits.
These are merely examples to sketch out the considerations. Thoroughly addressing the pitfalls of unknown unknowns, along with the possibilities of protection, would require a monograph rather than a twice-weekly column. Suffice it to say, though, that while mainstream investment analysis is very useful (I would write that, wouldn’t I?), it is far from complete. Some risk evades the numbers.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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