Risk, Optimism and Guardrails

 

This post has several roots.  Some of these have lingered in my thoughts for quite some time while others are quite recent.  How do risk and optimism interact?  The title of this blog; "Is it safe to go to Town" characterizes this very dichotomy.  As a reminder this blog was started during the covid shutdown and its seeds are in the simple dilemma of the risk I would take in walking from our home to one of the shops in the downtown core of the town we live in.  Optimistically I would walk to the town square and eat a meal and return home.  The risk would be that I would be exposed to covid and become ill.  Another kernel is our 401k.  Certain stocks or indices increase in value for no other reason other than the markets optimism for a company's future.  Recently I came across this podcast with Andrew Ross Sorkin.  The video is focused on his latest book about the 1929 stock market crash.  The title of the video is "Wall Street runs on optimism. History shows that may be risky. | BBC Global"

The video discusses risk and optimism as most people would imagine.  Too much risk is bad and is quite often associated with a unfounded optimism.  However no risk is bad as well.  Taking risks lead to advances in technology and is a key factor in society's progress.  I do have a post about Hope and Optimism.  However it does not address risk.  It's focus is on the difference between Hope and Optimism and relates the odds of success to them.  If the odds of success are favorable you are said to be proceeding optimistically.  If the odds are not favorable and you proceed you are in a state of hope.  

This previous post did not take risk into account.  How do we navigate the risks of our decisions.  How do we as everyday people avoid becoming overly optimistic.  The best place to start is definitions:

Risk:  Possibility of loss or injury 

Optimism: A doctrine that this world is the best possible world

I was not happy with Webster's definition of optimism.  Dictionary.com had a better definition:

a disposition or tendency to look on the more favorable side of events or conditions and to expect the most favorable outcome.

The first thing I notice is that the definition of risk is forward focused where as optimism is slightly rearwardly focused.  The best way understand this is to view optimism as an assessment of the current state.  This assessment does take into account risk.  However it chooses the best case outcome for a current decision.  Optimism is not a denial of risk it is a mind set that the risk will have minimal affects on our decisions.  Another term called optimism bias does ignore risk.  Optimism bias results in one underestimating risk.  Operating under optimism bias leads to a lack of preparation.  The damage incurred when a risk is encountered is more severe when one has not prepared for it.  An underlying theme of this post would be to be optimistic without venturing into optimism bias.

I have yet to read Sorkin's latest book (on my "to read" list).  However, I did want to address risk and optimism as it pertains to his book.  Referring to the BBC podcast the two main take aways, were that optimism is a powerful force and guardrails should be used to avoid being overly optimistic.  Sorkin does an excellent job of describing the optimism of the markets in 1929 (see some of the quotes below).  Although there did not seem to be adequate time to discuss the guardrails. In a nut shell markets used leverage to advance market growth.  Basically anyone could borrow a dollar today and buy stock.  By the next day the stock had increased in value and the borrower could pay back the dollar.  This cycle could continue and people could increase the amount of stock they owned.  More stock, more wealth.  This worked well until the markets stopped rising.  Once a downturn was encountered borrowers no longer had todays profits to pay back the money they had previously borrowed.  Eventually the downturn evolved into an epic crash and the markets lost about 90% of their value.  The guardrails that may have may have prevented this crash would likely have restricted the amount of leverage one could carry.

 I am not here to fix the stock market.  As I write this our 401k has experienced a couple of down days.  I am interested in how optimism and risk affect our decisions.  We as individuals take out loans (leverage).  These loans allow us to acquire needed items such as homes and cars.  A strong argument supporting mortgages is that a house will always increase in value.  I have personally experienced this a couple of times.  Optimism may play a part in our choice of a car and thus the size of our loan.  We may over extend on a car loan due to an optimistic career outlook.  There are risks in these decisions.  A home may not increase in value as quickly as we need.  A career can falter for a number of reasons.  In the past computer programmers could demand top dollar for their services. They are now competing with AI for employment.  The results of some of our decisions will not be realized for decades.  Retirement planning is an example of this.  So what guardrails do we have in place?  What keeps us from over extending our leverage.  In the larger market there are bank rules (some laws) to keep things in check.  The SEC monitors stock activity and traders to avoid excessive risk.  They do not always work as we all saw during the great recession of 2008.

Personally we do not have a governing body overseeing our monetary transactions.  A bank may refuse deny a loan if the borrower does not have the ability to repay the loan.  If a person is not credit worthy they may have trouble getting approved for a credit card.  These are limited examples, most guardrails are self imposed.  Google AI gives us the usual laundry list of financial guardrails.

The 50/30/20 rule

Emergency fund

Debt limits

Savings Rate

Portfolio rebalancing

These are all general common sense guidelines for managing finances.  They are well known and have stood the test of time.  Why then do people not follow them?  It is not just inadequate income that forces people over the guardrails.  Conservative surveys state that 25% of household earning 100k live paycheck to paycheck.  Some studies state a figure as high as 49%.  I think the issue is that the guardrails such as the ones above do not address the base issues that drive the behavior to over extend ones self.  This couple with the ease of borrowing makes it very difficult to stay within our guardrails.  I have see commercials where a buyer downloads a buy now pay later app at the checkout stand.  This borrowing transaction takes about as long as it would getting the cash from your wallet.  How is one supposed to stand up against this.

In writing this post I kept thinking about 2 previous posts.  One is about my spending code and the other is about gratitude.  In my spending code I think "I do have to spend money to live but I do not have to live to spend it" is appropriate.  I think acknowledging that money is important but money in itself does not enrich us.  It is a way to provide our material needs not our spiritual ones.  This item of my spending code goes hand in hand with gratitude.  Specifically, gratitude is a choice.  Choosing to be grateful needs to be the foundation of all our guardrails.  I believe that it is very difficult to maintain these guardrails without first being grateful.

The 50/30/20 guardrail states that 50% of our spending should be on "needs".  Without gratitude we may never be able to our needs at 50%.  Without gratitude we constantly seek more "needs".  So much so that "wants" morph into perceived needs.  Without gratitude we may not fully appreciate our wants and exceed debt limits and chase more "wants".  These extra "wants" than consume our 20% savings.  Without savings no retirement funds.  We should be grateful for our emergency fund.  If anything grateful for the peace of mind that comes with 6 months of expenses.  This allows us to weather a financial storm.

Optimism is a wonderful thing.  Gratitude puts optimism in the present. Gratitude gives us a solid footing to assess risk.  This then protects us.  Financial guardrails are fundamental ways to mange our finances and make decisions.  Without gratitude they are difficult to manage and maintain.  Start with gratitude then follow the guardrails.

Quotes about optimism from podcast:

Prosperity: Nobody wants to stop it

Euphoria: Hard to hold it back

When the music is playing you have to dance