Room for error

Feel free to reach out to PSG Wealth Manager Dawie Klopper directly.

So, how are you going to avoid getting an investment decision wrong? Unfortunately, you will not be able to. Mistakes are inevitable. You may feel you have a firm handle on everything, and then unexpectedly, Des van Rooyen is appointed Minister of Finance with the rand plummeting overnight, or Hamas invades Israel, and the oil price jumps unexpectedly. What can you do to ensure you are not caught on the wrong foot by a so-called black swan event?

In the context of finance, the economy or risk management, a black swan event refers to something unexpected happening and having far-reaching consequences. These events are often thought to be rare, difficult to predict and have a significant impact on financial markets, economies, or society as a whole.

Examples of black swan events in history include the 2001 dot.com bubble, the 2008 financial crisis and the 9/11 terrorist attacks. Locally, the appointment of Des van Rooyen marked such an event, and so did the 2020 Covid lockdown measures, which deeply hurt our economy. These measures were unforeseen, had a widespread impact and highlighted the shortcomings of traditional risk assessment models and strategies.

So, we must allow for error in our investment strategy by incorporating a safety margin in our investment planning. This will provide a safety net to protect against market volatility and unforeseen challenges, among other things.

If you allow for error, you will be a lot more prudent when it comes to making investment decisions.

Recognising the fact that we need to allow for the chance of error, Mohammed El-Erian, one of the world’s most widely known economists, says there are a number of things investors need in order to invest successfully. The first is resilience, which means you are able to absorb an error. Or, put differently, keeping an open mind – acknowledging there are things you do not know. It requires thinking out of the box and being agile. We should always ask ourselves: How resilient am I and what are my options? How adept am I in structuring my investments?

Secondly, diversification will also play a significant role in actually mitigating the impact of an error. In terms of investment, diversification is a risk management strategy which involves spreading your investments across various assets or asset classes to reduce exposure to any one investment or risk. The main objective of diversification is to achieve a more stable and potentially higher overall return on your investment portfolio while minimising the risk of substantial losses (or errors).

I have had dealings with people who needed a specific income for retirement that would only be achievable if the markets keep on rising, never coming down. And at the time of that person’s retirement, for whatever reason, the markets experience an unexpected 20% decline, and their retirement is compromised. Then we have to do all sorts of tricks to save their retirement. Perhaps they should have considered the fact that market declines are a regular phenomenon, to avoid an unpleasant surprise, and made provision for that in their planning.

In his book ‘The Psychology of Money’ Morgan Housel says, “Few financial plans that only prepare for known risks have enough margin of safety to survive the real world.” A margin of safety is scaling down your investment return expectations (e.g. by 2% p.a.) being surprised to the upside instead of being shocked to the downside.

For the sake of our own peace of mind, we need to allow for error, diversify our investments, and know the investment environment well enough to recognise the fact that volatility will always exist and that black swan events do occur regularly.