Recent volatility in the stock market, especially in many of the popular growth names, has a lot of investors considering whether they should be adjusting their portfolios.
Should they sell and lock in some of the gains accrued in the past year before things get worse?
Should they hold on and hope that this is just a small correction in an ongoing bull market?
Should they buy more as the market falls to take advantage of one of the few declines we have seen in recent months?
While these are simple questions, they don’t necessarily have simple answers. Investing and financial planning could be categorized as complex systems. To understand what this means, it might help to first consider simple systems. Simple systems have behaviors that are understandable and predictable. For instance, consider a room in your house with a light and a light switch. When you flip the switch on, the light comes on. Flip it off, and the light goes out. You know exactly what will happen any time you operate the switch.
The next type of system to consider are those that are complicated. Complicated systems have many more variables to work with; however, they will still have a single best outcome that can be achieved. There could be many paths to get to that outcome, but as long as you put in the effort, crunch the numbers, etc., the desired result should be repeatable. Think about sending a man to the moon. There is a great deal of effort and expertise involved and many ways it can be done, but as long as the calculations are made and things are built just right, the process can be done over and over again with the same result.
Now we come to complex systems. What differentiates a complex system is that they are made up of many components interacting to create the whole. With complex systems, there is not necessarily a linear path from cause to effect. You can provide the same input into the system many times and get different results. Think about raising children as a complex system. Their behavior is shaped by countless events and interactions as well as genetics. Because of this complexity, you can’t be sure of any particular outcome for a given input. If you raise more than one child, you can try to do things exactly the same, but you will get different results with each.
It is appealing to try to think of our financial lives as complicated systems. If we could just improve our calculations and measure things better, it would be possible to improve our results. Unfortunately, this isn’t the case. Financial markets are made up of millions of participants all with their own objectives. Decisions we make when thinking about just one perspective can have unintended consequences when viewed with a different perspective.
Consider one of the questions posed earlier, should investors sell some of their stocks to lock in gains? That is only looking at the perspective of trying to avoid potential losses. But that decision impacts other aspects of our finances. For instance, if the built-in gain is substantial, a large tax liability could be incurred when the sale is made. Perhaps it still makes sense, but the decision is less straightforward. There could be further interactions regarding taxation of Social Security benefits.
So how do we handle making decisions with this complexity? The first step is just knowing that none of our decisions will be perfect. Financial planning isn’t something that can be used to maximize wealth or some other specific outcome. It needs to be used to try to facilitate good outcomes by avoiding bad decisions. It helps to know what outcomes you will regret the most. In thinking about the decision being pondered here, would you be more upset if you sold something that continued to go up, or if you held on to it and it had a significant decline? Thinking about decisions in these terms gives us a framework to use even though we don’t have any way of knowing what the ultimate outcome will be.
David M. Nelson is president and CEO of NelsonCorp Wealth Management.