Wednesday, May 21, 2008

Consider More Than One Scenario When Making A Decision

Financial decisions based on a single scenario can sometimes be disastrous if the assumed scenario proves incorrect. Here are some recent examples of single scenario situations which turned into crises.
  1. Tech and Internet stocks can only go up.

  2. House prices will only continue to go up.

  3. Securitized debt has much lower risk that the individual loans.

We all know how these have turned out with the bursting of the tech stock and housing bubble and the current mortgage crisis. The consideration of multiple scenarios may have helped avoid some, but not all, of the issues experienced.

Of course, one can argue hindsight is 20/20:-) So I will provide an example, where the outcome is not yet determined, the current stock market direction. As I wrote in Time To Increase Cash Position, I believe the stock market is likely to go down in the short term. If I was 100% sure of a decline happening, I would sell all my stocks. Of course, I have also considered that I may be wrong and the market will advance.

To manage for the two possibilities, I have decided to sell stocks in my personal investment account, but leave the majority of the funds with our financial advisor invested in stocks. In addition, I have sold out of the money covered calls on some stocks. Thus, if the market declines, I have preserved some of the gain from March to May, 2008. If the market advances, I will still participate in the gain. For the scenario where the market declines significantly, e.g. over 20%, in the next few months, we have purchased a small amount of a bear market fund, which will have returns opposite to the market direction.

The consideration of these two scenarios has allowed us to design an investing strategy that partially benefits if either should happen. While this strategy will not gain as much as a strategy based on a single scenario, it also minimizes the losses (or missed gains) should I be wrong. Another benefit is that I worry less, have less stress and sleep better at night :-)

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2008 Achievement Catalyst, LLC

1 comment:

Rachel @ Master Your Card said...

I guess it is all about taking a calculated risk. Make sure you prepare yourself for the worst and have a back up plan. Do this at the beginning of the investment and then you can relax and concentrate on thinking positively about how well it will do.