October 04, 2008

Money & Pain

When I glanced through the headlines of the Financial Times this Wednesday, I came across an article which is so fitting of the current situation in the financial markets: http://www.johnkay.com/regulation/571

In his article: Why pain is good - in both medicine and finance, John Kay argues that “pain is beneficial because, on balance, evolution is smarter than you are at deciding how you should respond in situations that could hurt you.” This makes a lot of sense to me not just in daily life, but also in the world of finance and investing.

Pain in financial terms is often associated with risk tolerance and said risk tolerance, among other factors, is a very crucial component in terms of defining your specific investment strategy. Every broker and financial advisor is supposed to follow the suitability rule when making recommendations to clients.

The SEC defines Suitability as follows:
When your broker recommends that you buy or sell a particular security, your broker must have a reasonable basis for believing that the recommendation is suitable for you. In making this assessment, your broker must consider your risk tolerance, other security holdings, financial situation (income and net worth), financial needs, and investment objectives.In practice this means: your broker asks you a few questions, enters some tick boxes and then establishes a risk profile. Typically they have 5-6 choices to pigeonhole you from conservative to aggressive investor and their standard models then spit out a recommended asset allocation. So let’s say someone pigeonholed you as a “moderately aggressive” investor and gives you the recommended asset allocation. Do you know what this means? In terms of risk tolerance, how comfortable are you losing $1,000 or see your portfolio decline by $10,000, $100,000 or more? It all depends of course. Notice that I didn’t say your portfolio is down by 10%, 20% etc. I prefer looking at real dollar values and a good test is: check how many hours, weeks or months it would take you to cover your losses. And to say I’ve just lost 2 weeks/months of my annual income in real dollar terms hurts more than mere percentages.

Another way of looking at risk tolerance and pain has been outlined by Ken Fisher (the famous fund manager and Forbes columnist) in his book “The Only Three Questions That Count”. He argues that “these so-called risk rankings don’t mean anything – simply reflect no reality.” I couldn’t agree more with his comparison when he writes: “Most people are simply unable to assess how risk tolerant they are any more than most people who’ve never taken a hard punch to the gut can know how they’ll emotionally feel after one – until it happens to them a number of times and various ways – like a boxer.”

Based on current market conditions, some of us may be in for substantial financial pain and may continue to experience that pain for some time to come. We all have our own financial pain threshold but that threshold is also shaped by our financial behavior. Our financial behavior has been defined by an overabundance of credit. Granted, we really can’t afford the new gadget we “need” to have, but no problem - we don’t need to experience the pain of not being able to buy it, “0% interest for 12 months” is there to help. If we’re used to taking lots of heavy “financial pain killers”, for instance by using credit cards irresponsibly or using our home equity to buy the new cars, entertainment centers or other depreciating assets, then we must be prepared for some rude awakening and perhaps intolerable pain.

Our lives are filled with these financial painkillers but we must go back to basics to learn that small doses of pain should be tolerated to alleviate longer lasting, perhaps intolerable financial pain. That’s also true for investing and more so for the frequent trader. A day trader for instance experiences pain or pleasure and sometimes both even within the same day, especially in this wild markets.

But in the long run, with a good asset allocation and proper diversification you can alleviate a lot of pain. Nevertheless, pain is involved because you will have to forego some potentially higher returns now for alleviating much more financial pain later.Understanding the risks and more importantly, understanding your own financial pain threshold can be an immeasurable investment tool.

The financial markets are in disarray at the moment, and if your pain threshold is very low you may get out of certain investments at the wrong time. While I don’t suggest to start following the steps of Warren Buffett right now, in the long run, good companies with solid balance sheets and a good cash cushion will master this crisis. A few years from now, we may look back at these times as one of the best opportunities to buy solid companies at a discount.

Going back to the original point John Kay was making, financial pain cannot and should not be avoided completely. But it should be managed with the view of your own personal risk tolerance and your long term investment objectives in mind. If you’re not prepared to experience some pain at certain times, then you should not invest in assets with fluctuating prices (i.e. stocks, property, futures etc.). No pain, no gain – literally!

And lastly, associate the concept of financial painkillers to the $700bn bailout plan approved yesterday. As Warren Buffett noted this week, the rescue bill will help but is not a panacea to the underlying economy. The bill has been rushed through and it may be the necessary “painkiller” at this time. But it is arguable whether it may just prolong the inevitable and some massive “financial surgery” may be due at some point.

As always, I would appreciate comments or questions:

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