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Three financial futures that may or may not happen.  Part I: Knowledge and market volatility

Nothing is better than the changing of the seasons! In fall leaves change colors, decorating the landscape. In spring flowers come alive, bringing life from a long and cold winter. After tax season crumpled statements and papers get returned to a dusty filing cabinet. Ah, the end of tax season. A time when we tend to our financial wounds and declare we will be smarter about our taxes in the upcoming year!

The balancing of short term and long term tax planning is the answer to one of the more common questions I am asked during tax season, ‘What’s different between what CFPs do for clients versus CPAs?’. One considers the short term tax consequences of our decisions, and the other the long term tax consequences. CPAs act in the past and present. ‘How do we work on your current year taxes to best benefit your bottom-line?’ Financial Planners consider the future and how it may affect your bottom-line later, and then consider how to prepare accordingly. CPAs are historians, whereas Financial Planners, for the purpose of this explanation, are fortune tellers (albeit, with more scientific crystal balls).

This does not mean the two professions butt heads. In fact, over the past few decades the two professions have found significant value in working together for the betterment of their clients. This doesn’t mean the relationship is fluid, and I have found that the biggest task I have when working with tax professionals (those completely removed from the financial planning realm) is to help them conceptualize that unlike their profession, financial planning is not only based on known variables, but assumed variables. This includes variables that may not even exist yet.

This month’s ‘For Your Consideration’ is the first of a three part series. I want to bring readers into my thought process as a Financial Planner, and review three common planning topics that are pure ‘assumptions’, and how I think they might change over time.

Topic One: Will Investment Behavior Become a Thing of the Past?

In order to develop investment strategies, I first determine what a client is trying to accomplish, determine historically what investments have provided the needed rate of return (within a certain margin of error), consider the client’s time horizon and risk tolerance and away we go. This strategy is built on the belief that volatility will always exist. Risk versus reward. The higher a return you want to acquire, the more volatility you must be willing to accept. Volatility is caused by a number of factors, including systematic and unsystematic risk and investor behavior.

The latter is, in my opinion, the most crucial. Investor behavior (most often bad behavior) is what causes the most volatility in the market, and over the long term is a key component of investment growth. However, what if there was a paradox which caused investor behavior to change?

There is a concept in investing called the ‘efficient market hypothesis’. To summarize, the concept is that the current price of investment already reflects all known information and getting ‘a deal’ on a price is rare. There are various subsets of this theory, but the concept is that the more investors know, the less surprise (volatility) there is for an investment.

In the age of technology, what if we were to get to a point where it’s impossible to not know all available information? Would we get to a point where volatility becomes a thing of the past and all investments move in a similar sloth like manner as Treasury Bonds? If risk goes away, so does the potential of large growth. Will ‘the markets’ become entirely commoditized, leaving rates of return up to the current economic environment?

I’m actually not as concerned about this theory coming true, as long as humans continue to have emotions and act on them, instead of acting rationally. If robots one day become the majority of the population, then we can revisit this theory.

Next Month: Off to College, Or Not.

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