Enough

[KenHall]

I came across this excerpt from an Appendix in the book “Reducing the Risk of Black Swans” by Larry Swedroe, the book itself is unmemorable but this piece has stuck with me and I think it about it now and again when assessing risk or systems with a high CAGR but also a high MaxDD.
Thought I’d share for educational purposes as someone may find it useful…

To know you have enough is to be rich.-The Tao Te Ching

Author Kurt Vonnegut related this story about fellow author Joseph Heller: “Heller and I were at a party given by a billionaire on Shelter Island. I said, ‘Joe, how does it make you feel to know that our host only yesterday may have made more money than your novel Catch-22 has earned in its entire history?’ Joe said, ‘I’ve got something he can never have.’ And I said, ‘What on earth could that be, Joe?’ And Joe said, ‘The knowledge that I’ve got enough.

“What Heller was saying was that you are rich when you know you have enough. Of course, everyone’s definition of “enough” is different.From the perspective of an investment plan, how you define enough is of great importance because it defines your need to take risk-the rate of return you require to achieve your financial goals. The more you convert desires (what might be called “nice-to-haves”) into needs (“must-haves”), the larger the portfolio you will need to support that lifestyle. And the more risk you will need to take to achieve that goal.

Those with sufficient wealth to meet all their needs should consider that the strategy to get rich is entirely different from the strategy to stay rich. The strategy to get rich is to take risks, and concentrate them, typically in one’s own business. However, the strategy to stay rich is to minimize risk, diversify the risks you do take, and to avoid spending too much. In other words, if you have already won the game meaning you have a large enough portfolio to meet all your needs-it is time to change your strategy and develop a new investment plan. The new plan should be based on the fact that the inconvenience of going from having enough to not having enough is unthinkable.

When deciding on the appropriate asset allocation, investors should consider their marginal utility of wealth how much any potential incremental gain in wealth is worth relative to the risk thatmust be accepted to achieve a greater expected return. While more money is always better than less, at some point many people achieve a lifestyle with which they are very comfortable. At that point, taking on incremental risk to achieve a higher net worth no longer makes sense: The potential damage of an unexpected negative outcome far exceeds the potential benefit gained from incremental wealth.

The utility curve in the following chart illustrates this point.[img]blob:https://edu.thechartist.com.au/01eb16b7-0a38-4cba-88ec-c9d2fdbd0001%5B/img%5DEach investor needs to decide at what level of wealth their unique utility of wealth curve starts flattening out and bending sharply to the right. In the preceding example, that point is about $10 million. For you, it might be $500,000 or $1 million. There is no one right answer. Just an answer that is right for each individual. However, whether the figure is $1 million or $50 million, beyond this point there is little reason to take incremental risk to achieve a higher expected return. Many wealthy investors have experienced devastating losses (does the name Madoff ring a bell?) that could easily have been avoided if they had the wisdom to know what author Joseph Heller understood.

A lesson about knowing when enough is enough can be gleaned from the following incident. In early 2003, Larry met with a 71-year-old couple with financial assets of $3 million. Three years earlier, their portfolio had been worth $13 million. The only way they could have experienced that kind of loss was if they had held a portfolio almost all in equities and heavily concentrated in U.S. large-cap growth stocks, especially technology stocks. They confirmed this. They then told him they had been working with a financial advisor during this period demonstrating that while good advice does not have to be expensive, bad advice almost always costs you dearly.

Larry asked the couple whether any meaningful change in the quality of their lives would have occurred if, instead of their portfolio having fallen almost 80 percent, it had doubled to $26 million. The response was a definitive no. Larry then noted that the experience of watching $13 million shrink to $3 million must have been very painful, and that they probably had spent many sleepless nights. They agreed. He then asked why they had taken the risks they did, knowing the potential benefit was not going to change their lives very much, but a negative outcome like the one they experienced would be so painful. The wife turned to the husband and punched him, exclaiming, “I told you so!”

Some risks are not worth taking. Prudent investors do not assume more risk than they have the ability, willingness or need to take. The important question to ask yourself is: If you’ve already won the game, why are you still playing?

NEEDS VS. DESIRES

One reason people continue to play a game they have already won is that they convert what were once desires (things nice to have, but not necessary to enjoy life) into needs. That calculus increases the need to take risk. That, in turn, causes an increase in the required equity al-location. And, that can lead to problems when risks show up, as they did in 1973-1974, 2000-2002 and again in 2007-2008.

MORAL OF THE TALE

Failing to consider the need to take risk is a mistake common to many wealthy people, especially those who became wealthy by taking large risks. However, the mistake of taking more risk than necessary is not limited to the very wealthy. Ask yourself how much money buys happiness. Most people would be surprised to find that the figure they come up with is a lot less than they thought.

For example, psychologists have found that once you have enough money to meet basic needs like food, shelter and health care, incremental increases have little effect on your happiness. Once you have met those requirements, the good things in life (the really important things) are either free or cheap. For instance, taking a walk in a park with your significant other, riding a bike, reading a book, playing bridge with friends or playing with your children/grandchildren does not cost very much if anything. And switching from a $20 bottle of wine to a $100 bottle of wine, or from eating in a restaurant that costs $50 for dinner for two to one that costs $500, likely won’t really make you any happier.

Moreover, even a $50 dinner every evening likely does not yield a whole lot more happiness than a $50 dinner every other evening.When developing your investment policy statement, make sure you have differentiated between needs and desires, and then carefully consider your marginal utility of incremental wealth so you can determine if those desires are worth the incremental risks that you will have to accept. Knowing when you have enough is one of the keys to playing the winner’s game in both life and investing.

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