Weighing Worst Case vs. Base Case
Financial planning, like morning commutes, is often more sensitive to tails of the distribution than the average.
If long-run averages are anything to go by, the expected time for driving my daughter to school is around 15 minutes. But this is an example where the range of outcomes is more helpful than the average.
This morning, we breezed through every traffic light and made it in just over 10 minutes. On the (many) days a collision is obstructing traffic, the drive can take up to 20 minutes. So how early do we try to leave the house? Twenty minutes before school starts. That’s because there’s no penalty for arriving too early but there is for arriving late. We’re calibrating to the potential worst-case scenario, not the expected one.
Investors often face a similarly asymmetric set of consequences in preparing for their financial goals. Future cash-flow obligations may not be as inflexible as the school bell, but most investors still have a minimum required to maintain their lifestyle. This dictates how investors may evaluate the tradeoff between expected return and range of outcomes.
Risky assets that increase expected return may grow your portfolio value faster and raise the ceiling on how much you can spend. But if this comes with a wider range of outcomes, falling short of the minimum requirement may reach an unacceptable likelihood. In goals-based investing, like school commutes, the tails of the distribution may be more meaningful than the expectations.
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