Let's say that we during adventurous travels in the Hindu-Kush fall victim to a sinister maharaja.
The whole affair has something to do with lovers, defamation and the beauty of punjabi men, that sort of thing.
To our horror, we learn that the punishment for debatable behavior is to be thrown out of a cliff. The maharaja then, according to ancient custom, gives us a choice: being thrown out of a ten meter (30 feet) cliff, or ten times from a one meter (three feet) cliff.
A big hit is, most would agree, much worse than many small hits. So either one has to make sure to chose the smaller hits, or else have a way to avoid the effects of the big drop.
The drop is of course our metaphor for volatility. Volatility, as our sinister maharaja, is the harbinger of ruin, and it's not symmetric.
But volatility can also be the omen of good fortune. Let's say that one has prepared with a thick, bouncy mattress below the cliff (needs to be prepared in advance), or has learned how to fly a squirrel suit (takes some deliberation). In the last case, larger volatility might even be needed to get us somewhere.
Volatility is also fractal. In the unlikely event that one survives the first drop, one might roll over the edge down below and find an even worse drop. One can lose 50% many times over when the markets go down.
Volatility might seem to be calculable and controllable, but then shows up in new shapes unheard of; tulips, house markets, failing financial institutions, or the maharaja's crazy son, for instance.
Or perhaps the maharaja's (wooden) palace catches fire. An once-in-a-lifetime, high-volatility-event. And all the fire exits will be blocked by investors - or rather, ministers and courtesans, perhaps - that try to escape the burning palace, just as we ourselves might find that we need that fire exit.
Some might laugh in the face of volatility. Some might want not to think of it. Some might earn from it, with that mattress and squirrel-suite.
Whatever we might think of our tolerance, it's not naïve to expect that volatility might hurt more than our fragile human constitutions can take.
The wise man prepares in advance. And while preparing our defenses, remember that it's better to protect against ruin rather than chase the higher return.
A high-volatility mountain range where it pays of the be both wise and prepared.
CC-4.0 Zeeshan-ul-hassan Usmanif
Let's look at three strategies to reach financial independence, from a Hindu-Kush perspective.
- The very very heroic approach
- The heroic approach, including mattress
- The squirrel suit approach
1. The Very, Very Heroic Approach
A very, very heroic approach to financial freedom, akin to dare the maharaja's crazy son, Prince Singh, on a duel, is to start a company. To some extent or another, it's a gamble, heavily relying to our own capabilities and wit. No matter how good we fight there will be luck in the equation.
We can fund the company with its own cash flows, or even more volatile: lend a bunch of money, buy something of value to others (rental properties, someone?) and sell the produce of the investment to others.
Then, lay awake at night at pray that the company doesn't burn to the ground, a competitor shows up and the market demands stays, or the Prince having a nasty trick up his sleeve.
Darius I, early ruler of the region.
It's as old as the the written word. Perhaps the written word even exists because of this strategy to wrestle volatility and get rich. And if you're lucky, one might get very wealthy with this approach - killing the prince, inheriting the whole of the Raj, et cetera.
But ruin can very well be complete, and severe.
2. The Very Heroic Approach
A less, yet still very heroic approach is to bet on all companies in the economy instead.
The very heroic approach is to buy a broad stock market index fund, with the attitude that in the very long run the stock market will be going up.
Why is it heroic, and why do we say in the very long run? Well, because it can take 10-20 years to recover after a big drop for the stock market.
A few times in one's lifetime, one is likely to hit that big negative event. We know big volatility will come, because what is an unlikely event in one year suddenly becomes a likely event in ten years. Then, like our ten meter drop above, one better be of an unusually strong built, or have something prepared in advance to survive the drop.
No, we hear you scream, you wrong, I've heard that the markets recover much quicker! But we're so sorry. Let's not mix up the duration of a crisis (often quite short) with the time for recovery of the stock market (can be several decades long). But yes, there is hope. Bear with us.
The way to survive this for many is to try to construct a mattress that will dampen the fall.
The mattress can be a cash buffer one can live off during the worst year, or focus on the cash streams created by (hopefully) less volatile dividends.
Another way is to have complete blind faith in the magic of back-testing and rely that the 4 percent rule* is not just a product of back-testing but more akin to a universal constant.
So there are ways to try to get around the volatility of the stock market as a total. Open in new tabs for future reading!
Yet, the attitude to risk still needs to be, well, heroic to say the least. In the accumulation phase, the goal of financial independence can suddenly be postponed five years or more into the future when the stock market misbehaves.
In the financial freedom phase, the size of the stash might be reduced for decades, and if one is unlucky, what felt like a safe margin for freedom might become a very small margin indeed. If something unforeseen hits - as it has a tendency to do in real life, we dare to say - that might even make the stash never recover again.
3. Learning to fly on volatility
The alternative to the mattress might be to learn how to fly in times of big volatility, perhaps even understand how to earn from it.
Instead of relying on one asset class, we have gone for four. The advantage with aiming for a set of very different asset classes is that they move much less in tandem, yet each and one of them takes part in the economic growth of humankind over time.
Another appetizing property is that the portfolio profits from volatility in most cases. Each and one of the assets in the portfolio would be very dangerous to own by itself, but because they are put together, they create something that is much less dangerous, and will often move counter to the stock market during a bad year.
So when volatility strikes, with big drops in any single asset-class, we can fly over the cliff with a surprisingly stable flight despite all the rough edges that are zooming past below us.
And the types of portfolios we chose has an okay performance, getting us much more safely to financial independence by neutralizing the effect of a big drop.
So with the right preparations, one can profit from the sinister maharaja's proposition, and both earn from the volatility that might kill others, and in the same time fly safely over rough terrain.
Read more about our thinking around our portfolio here:
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