“In a world of possibilities, imagine yourself as one.” -DNF
While I’ve seen “DNF” used to identify those who did not finish a race, in this case, the internet has failed me, and I have no idea to whom this quote should be attributed, so I’m designating it “did not find.” Thanks to whoever wrote it! Without the context of today’s topic, I wouldn’t find a lot of meaning in the quote, but it is now striking me to be surprisingly profound. Maybe it’s just me, though. On to more important things…
Super Nova
I’m by no means a science junkie, but I am definitely a sucker for shows about the latest breakthroughs in our understanding of humans and the world around us. As my wife would tell you, there’s usually a sizable backlog of these shows on our DVR at any given time. One of the best in this area is Nova, which is on PBS. The first time I remember watching it was in a hotel room circa 2003, and it focused on physicist Brian Greene’s 1999 book, The Elegant Universe.
I was immediately captivated by the topic. Were there really eleven dimensions around us, including eight hidden dimensions in addition to the three (length, width, depth) we experience every day? And could string/superstring theory be the explanation that reconciles small-scale (quantum mechanics) with large-scale (general relativity) behavior – i.e., the long-sought Theory of Everything (TOE)? These are among the topics the book set out to explain. I was fascinated and immediately bought the book (not from Amazon, although books were one thing they did sell at that time). Admittedly, I’ve barely followed the developments in physics since that time (except for the Higgs boson discovery at CERN), but I continue to have some inexplicable internal longing for the day when TOE becomes a reality – as if suddenly the world will then make complete sense to us humans.
Financial Unification
Switching abruptly to finance, if there is one “theory” that can serve as a consistent framework across situations of all types and sizes, it’s financial planning. Concisely, it’s the process that allows us to consider many variables – including cashflows, accumulation/spending goals, risk-management needs, tax/estate implications, etc. – and find solutions to help achieve specific financial goals. That resulting plan can help drive everything from acceptable risk/reward attributes (returns, income, volatility) down to investment selection itself. It may be obvious that a portfolio for a $100 million endowment client will look very different than that of a $1 million private client; but, perhaps it’s less intuitive that the portfolios and strategies used for two $5 million clients often differ significantly, as well, due to their unique circumstances. Components of each situation may “rhyme,” but proper planning requires custom solutions for each.
Outcomes-Based Physics?
As I mentioned above, there is something deep within me that believes the TOE will be proven. In fact, since learning of the TOE concept, I have never until this moment entertained the idea that it may not exist. But, what if it doesn’t? Does the planning framework of space-time simply require one solution for the microscopic world and another solution for the macroscopic world? Are we overcomplicating the issue by trying to find a “one-plan-fits-all” solution? At least to a layperson, it wouldn’t be any more surprising than other mind-bending features of the universe, like black holes, wormholes, or quantum entanglement. Fortunately, we don’t need to answer such incredibly difficult questions in our comparatively simple mission of focusing on financial planning and investment management.
Isn’t This An Alts Blog?
More specific to alternative investments, investment selection should be rooted in financial planning, just like the overall portfolio itself. Only after understanding what risk/return/income attributes are needed for a particular situation can we find appropriate solutions. Not only that, but planning will also help us understand additional factors, like:
- Investor qualification (e.g., accredited, qualified client, qualified purchaser) and what types of investments may or may not be permissible
- The sizing that should be used (e.g., a 1% portfolio position? A 5% position?)
- What liquidity is needed or – phrased differently – what illiquidity is acceptable
Note that the above questions cannot be independently answered, as they are inherently entangled. That is the beauty of financial planning: it helps us take all of these things into account comprehensively.
He’s Baaaaack
Now, imagine that every decision you’ve ever considered was able to play out in a different world. In one world, you married your high school sweetheart; in another, you pursued a career in art instead of accepting an accounting job after college (if you have actually done either of these things, then I apologize for the poor analogy, but please bear with me). Over 15 years since my introduction to Brian Greene, I recently stumbled upon him on a podcast, and he’s now discussing the Many Worlds Interpretation (MWI) of quantum physics. In my simplistic non-physicist brain, the essence of MWI is this: infinite parallel worlds to account for unlimited possibilities. Literally, everything imaginable (and unimaginable) happens, just not in our world.
MWI-DD
Quantum mechanics and parallel worlds may be the farthest thing from investment analysts’ minds as they carry out research and due diligence (DD) processes. However, an inherent part of those efforts is to consider various possibilities of what could happen in the future and how it may impact a given investment: i.e., they have to imagine the many investment worlds that could occur.
While it’s standard practice to contemplate risks and potential outcomes when examining an investment, it’s very limited in scope relative to the many-worlds concept. Typically the conversation focuses on more “in-the-box” thinking, consisting of base-case, upside-case, and downside-case scenarios. That may be very pragmatic and convenient, but these outcomes are inherently biased by our own experiences. As we saw in recent posts about hedge-fund blowups, considering more possibilities could have real utility in helping us avoid otherwise unexpected risks.
Black Swans
Rest assured, the question of “how would this portfolio perform if the real estate market collapsed and the world entered a severe financial crisis?” was not prevalent in pre-2008 investment meetings. Still, it likely has been uttered millions of times since then. Similarly, a global pandemic featuring a violent economic shutdown was not on my radar before March of 2020, so stress-testing portfolios for such a scenario was not “a thing.” But you can bet it has been and will continue to be on the minds of analysts, portfolio managers, and advisors for the foreseeable future.
In hindsight, it is obvious how and why those horrific events came about and why most of us didn’t see them coming: humans are poorly equipped to forecast the future. More bluntly, as Neil Pasricha points out in this TED article, “We suck at it.” For example, people vastly underestimate how much they’ll change in the future, even though they understand that change has been a constant of their past. Basically, we assume that the status quo will remain indefinitely, and that seems to be because of the way we’re wired. As the article also discusses, our “status-quo bias” could feel good if we’re living exactly the life we always wanted, but it could be depressing when enduring a challenging period.
“Realing” It In
One doesn’t need advanced physics to understand that there are many possible courses our lives and investments may follow; the challenge is figuring out which are most likely to occur. Ultimately, the possibilities are endless, but there will only be one path with one outcome. Regardless of whether infinite parallel worlds exist, we are relegated to only one of them, and we must plan accordingly. At the same time, there is utility in contemplating a broader set of potential outcomes to help enhance risk management on multiple levels.
The universal financial truth is that we can develop a financial plan specific to our unique circumstances and desires. Further, that plan can become more robust by a) considering a broader set of outcomes to drive the allocation framework itself and b) incorporating the world beyond stocks and bonds into our investment selection, aka the alternative investment universe.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
