How to Think about a Risky Economy
My firm and I have served business owners for over 25 years, but the questions I get now are some of the toughest I’ve ever faced. In the past, a typical meeting would focus on the client’s family, his or her investments, some tax issue perhaps, and certainly how the business was running. Except maybe in an election year, we rarely discussed Washington or Springfield (we are in Illinois).
Has that ever changed. We still talk about normal business issues, but the discussions usually then turn to the turmoil in Europe or what one of my business owners refers to as the “complete dysfunction” in Washington. Everyone wants to know--as you probably do, too--what impact the deficit will have on the future of the country, and how much you have to worry about Europe. The other day I was taken aback when a client asked whether he should spend less on himself so he could help his children, who may need extra assistance because of where the country is headed.
Making economic predictions is an iffy practice in the best of times, but it’s particularly so now. At this point in history, politics trumps economics. Put simply, the fate of the European Union and the U.S. recovery are now in the hands of people whose motivations are colored by national pride, lobbyists, fund-raising, no-tax pledges and a hundred other things that have nothing to do with economics. That makes the future impossible to handicap.
The word a lot of economists use these days is “binary.” Either the politicians will figure things out, and the next few years will be pretty good, or they won’t figure things out, and the outcome will be horrible. There’s not a lot in between.
How do you make any financial decision at such a time? Here’s what I tell my clients:
First, realize that you are likely underestimating the amount of change that lies ahead. Behavioral economists use the terms “status quo bias” (belief that the way things are is the way they’ll stay) or “anchoring” (fixating on some milestone in the past as the way things are “supposed” to be) to describe people’s tendency to discount major changes when they come. I don't know what's going to happen either; but I'm sure that if you aren't ready to change you're in trouble.
Second, when you weigh risks, calculate not just the likelihood that things could go wrong, but also how far wrong they could go. Statisticians use the term “fat tails” to describe extreme outcomes that are more likely than you think. And right now the negative "tails" are a lot fatter than the positive ones. In the European debt crisis, for example, a 2008-style financial meltdown is not the vision of some wild-eyed Cassandra. It’s a real possibility.
Finally, you need to see your choices through the framework of your own situation. If you’re 67, say, and two years away from throwing in your chips on your business, I’d suggest you consider not waiting. You may not have time to cope with a bad outcome. You can't control the future, but you can control how much risk you take.
Mohammed el_Erian, the CEO of the influential bond investment company Pimco, recently spoke to a bunch of us planners, and warned that the global economy is in the midst of a radical realignment. Decisions by policy makers have the opportunity to do great harm or great good, he warned, but no one knows which they'll choose. Pimco and el_Erian are pessimistic; I tend to think that people will figure this situation out. But I agree with el_Eian on one thing: Talking about change is cheap. In your business and your money, you need to be prepared to act when things change. The old answers won’t do.
MARK BALASA, CPA, CFP is Co-Chief Executive Officer and Chief Investment Officer of Balasa Dinverno Foltz LLC. Mark has been named seven times as one of the “Best Financial Advisors” in the U.S. by Robb Report Worth magazine.
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