How Confident Can You Afford to Be?
When flying on a commercial airline, how confident are you that your plane will arrive at its destination without accident or incident? Are you 90% certain? 99%? More than 99%? Our willingness to routinely board commercial airplanes suggests that our confidence level is well in excess of 99%. Our confidence is not ill-founded, fortunately, as the U.S. Federal Aviation Administration (FAA) estimates only 7.6 accidents per 100 million passenger flight hours in 2012, implying a success rate of more than 99.999%.1
How confident are you that your flight will arrive on time? Are you 75% sure? 50%? Less than 50% certain? The FAA suggests that 83.12%2 of flights arrive on time (though we all recognize that airlines frequently “pad” their flight times to increase the chances of on-time arrival).
Finally, when flying on a commercial airline, how confident are you that your in-flight experience will be comfortable, pleasant, and relaxing? Are you 50% certain? 25%? Less than 25% sure? In an era of narrower seats and wider passengers, parsimonious snack policies, and over-stressed flight attendants, many of us possess a low confidence level that our experience in flying will be a positive one.
Why do we demand a much higher confidence level for arriving safely than for arriving on time? And why do we demand a higher confidence level for arriving on time than for arriving in comfort? The answer is clear: the pain of loss in the case of a plane crash (sudden, fiery death) is much greater than the pain resulting from a 3-hour delay in arrival, and the pain of arriving at your destination 3 hours late is more intense than the pain of insufficient legroom or a loquacious seatmate.
There is little we can do as individual airline passengers to improve the probability that the flight will arrive safely. Training requirements, the air traffic control system, obligatory maintenance procedures, and pre-flight checklists have already “maxed out” our confidence level regarding flight safety. It is possible to increase our confidence that the airplane will arrive on time, but it is costly. We could take an earlier flight to make sure we arrive in advance of our deadline, but that strategy imposes an opportunity cost on our personal time. We could charter a private jet, thereby eliminating some (but not all) of the typical sources of flight delay, but chartering dramatically increases our cost of travel. Similarly, we could upgrade from economy to the first-class section in order to improve our chances of a comfortable flight, but that approach also costs more and does nothing to improve our chances of flight safety or on-time arrival.
The Goals-Based framework for investing utilizes the same concepts of confidence level, hierarchy of needs, and cost of funding to organize our investments into an improved asset allocation. Individual financial goals can be categorized as Needs (“must have” goals requiring, for example, 95% confidence), Priorities (“wants” requiring 75% confidence) and Aspirations (“nice to have” goals requiring only 50% confidence). The investor’s pain of loss is much greater for Needs than for Priorities or Aspirations, and the Priorities and Aspirations come into focus only after the Needs are fully met (much like the goals of on-time arrival and inflight comfort are important only after the goal of flight safety is fully satisfied in the minds of airline passengers). The adjacent diagram illustrates the analogy of airline travel and Goals-Based investing.Confidence levels in investing are a function of two important factors: portfolio risk and time. Less risky portfolios generate more predictable outcomes and, consequently, higher confidence levels for investors. This is especially true when the time horizon is short. Riskier portfolios, while potentially producing superior average annual investment returns, experience more volatility in returns from one year to the next, and may even fall short of expectations over longer time periods, both of which lead to lower confidence in our ability to achieve stated goals.
If we need to fund a specific personal financial goal with 95% confidence in a relatively short time frame—say 1-5 years—we typically would prefer a portfolio of safe, liquid investments (e.g., cash, short-term Treasuries) to one allocated to riskier or less liquid holdings (e.g., stocks, private equity). If we invest today in the riskier portfolio, there is a much greater chance that we will lose money in any or all of years 1 through 5 than if we invest in the safe portfolio. The only way to overcome this potential loss from the riskier portfolio is to invest more dollars to fund our near-term goals, such that if we experience a loss in market value we will still have sufficient assets to meet our goal. Consequently, we would prefer to fund near-term, high-priority goals with less risky portfolios because they produce more predictable outcomes and effectively reduce the cost of funding those goals.
However, if the time horizon is long enough—say 20 or 30 years—a riskier portfolio of stocks and private equity investments might be ideal. Time tends to smooth out volatility, as the additional expected return from riskier portfolios typically and gradually overcomes (through compounding) the unpredictable nature of individual year-by-year returns.
We can make several generalized statements about portfolio risk, confidence levels, and the ideal asset allocation:
- The best asset allocation is the one which minimizes the cost of funding our future goals at our desired confidence level.
- Our desired confidence level for any specific goal is very personal, based on the fact that we value some goals more than others and feel a more intense pain of loss for high-priority goals than for lower priority ones.
- For any individual investor, certain goals have a longer time horizon than others.
- For a given required confidence level (e.g., 75% certainty), the longer the time horizon, the more portfolio risk we can safely assume.
- For a given time frame (e.g., 5 years), the higher our required confidence level, the less portfolio risk we can safely assume.
- Our ideal overall portfolio allocation should be a blended average of the individual sub-portfolios that best achieve our specific goals at their respective confidence levels and time horizons.
So, how confident can you afford to be when investing? The answer is “It depends.” As in flying on a commercial airline, it depends upon how far you need to travel, the time at which you need to arrive, and how comfortable you wish to be during the trip.
1 http://www.faa.gov, FY 2012 Destination 2018 Scorecard, June 2012.
2 Ibid. On-Time Arrival Performance, July 2011 – June 2012.