The vast majority of businesses manage their operations according to a plan. That plan may be as simple as an entrepreneur writing down a few goals on a napkin, or as complex as a massive set of instructions covering the day to day, month to month, year by year, or decade by decade actions required to maximize profits. However complex the plan may be, it will guide the business’s use of its capital for future growth. This entire process is dependent upon the extremely difficult practice of forecasting.
As individuals, it is a good idea to treat the savings you’ve put aside for future use as a business would. You choose a goal for those funds, and then make plans based on assumptions of the future. When working towards maximization of profits, businesses realize there are certain areas in which they lack the knowledge and training required to meet that goal, so they outsource those portions to other professionals.
Our firm is fortunate in that there are so many individuals and organizations who have been willing to outsource to us the expertise required to help meet their personal financial goals. Part of that process requires us to create forecasts, even though we know how hard and subject to error any forecast can be. In an attempt to combat the wide margins of error and the false hope any single forecast can create, we recalculate our forecasts monthly. We update the ever changing data, revisit previous data, and make changes when we believe it is necessary.
One goal of our forecast is to help us lessen three major areas of risk: market risk, individual security risk, and behavior risk. And it is fairly good at helping us identify and control for market risk and individual security risk. The quantitative approach involves known numbers, and over time those numbers add to a semi-stable set of data that can help us decide if we are being offered bargains or are being overcharged for our investments. We would obviously prefer to buy low and sell high. Buying low at times can be difficult, though, and if there are no bargains available, we would much rather wait for better opportunities.
Our forecast is not able to easily deal with behavior risk, however, and by that we mean the bad investment behavior that we are all subject to: buying and selling based on our emotions. The marketplace as a whole is ruled violently by the greed and fear of its market participants. Most people end up buying high and selling low. To do the opposite, to do what we preach, takes substantial amounts of personal strength. Although our forecast cannot predict the future whimsy of the masses, it offers us a fundamental common sense base from which we can combat our poor behavioral urges.
The main purpose of this forecast is to guide us in allocating our investments between common stocks, with their higher level of risk, and US Government issued bills, notes, bonds, and/or FDIC insured certificates of deposits. Government obligations and FDIC insured certificates are as close as we can get to a simple, easy to understand, low risk investment. By comparing our estimate of the potential return of stocks to the known returns of these relatively risk free investments, we can quantify the potential increase in return for taking a higher level of risk.