If we plan our financial future with invalid assumptions we will end up with an invalid answer – never a good thing. After all, we know what they say about assumptions.
Prior to 2008, several financial planners and investors were making decisions based on a “normal curve” of the markets. A normal curve is a bell shaped curve. It allows you to predict the probable outcome of an investment based on the market’s previous performance. Unfortunately, predictions made with a bell curve are done with invalid assumptions. Recently, we saw the severe repercussions when those predictions are wrong.
Rather than throwing out the whole curve, the new approach is a “fat tail curve.” This is the same bell shaped curve, only with fatter tails. The fat tails make the probability of extreme events, such as 2008, a lot higher. The problem is, this is still a generalized bell shape curve and predictions are still made with invalid assumptions.
To avoid the uncertainty of predictions, several planners and investors have and do use asset allocation. This type of investment diversifies assets across different classes so that when one goes down another goes up. Overall, this reduces risk and improves returns. Unfortunately, in 2008 when an asset went down another didn’t rise. It fell. They all fell.
Predictions made with false assumptions, such as normal curves and secure asset allocation, left nearly everyone in a big bind during the Great Recession. By keeping our focus on the long term, rather than the short term, we can plan for economic dips. We can avoid some of the past mistakes.
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