“Greece is a tiny player in global capital markets. Its default is 100% certain,” says Larry Swedroe, Director of Research for The BAM ALLIANCE and the author of 14 books on investing, including his most recent, The Incredible Shrinking Alpha, co-authored with Andrew Berkin.
“The only question is how much and what they default on,” Swedroe continues. “But with a GNP that is similar to Rhode Island’s, Greece’s default should have little to no impact on the world’s economy, at least not directly.”
So why is everyone so worried?
Because raging forest fires are kindled from a single, tiny spark. “Greece’s default could trigger a broader contagion, like a run on Portuguese banks or a lack of confidence in the ECU, that may have wider ranging implications for larger economies,” says Swedroe, my colleague.
Regardless of the country’s relative unimportance on a global economic scale, it could be Greece’s current crisis that causes worldwide combustion. Or it could be the imminent default in Puerto Rico. But it also could’ve been ISIS or Libya or the financial woes of bigger economies, like Spain and Ireland. Heck, it could’ve been Greece in 2012 or 2010. Except that it wasn’t.
Risk Vs. Uncertainty
The real worry over Greece is the same as what ultimately pains us about investing in “the market” in general. It’s not calculable risk that we fear when we’re planning ahead for the potential of any individual event, or even a convergence of events, to devolve into a catastrophe (the proverbial “black swan”). It’s the inherent uncertainty of such an event occurring that leads us to fret.
“There is a difference between risk and uncertainty,” says Swedroe, hearkening the words of economist, Frank Knight. “Risk is when you can know the odds or at least estimate them extremely well, like at the roulette wheel or even in life insurance. Uncertainty is where you cannot even get a good estimate of the odds.”
Investors would certainly prefer to deal exclusively with calculable risk, but we just are not able to shed uncertainty. Market corrections and crashes aren’t an “if” but a “when.” We simply can’t accurately predict the next 9/11 or 2008 financial crisis. That’s the bad news.
The Good News
The good news is that, historically, we’ve been well compensated by the market to endure its inherent uncertainty. The even better news is that we can prepare for uncertainty. We can orchestrate portfolios designed to function in—and even to take advantage of—uncertainty.
But to do so effectively, you must first be honest with yourself. How much pain can you handle? How much of your portfolio can you lose without abandoning whatever strategy you’ve put in place?
How Much Uncertainty Can You Handle?
If, for example, you can’t possibly bear the notion of losing more than a quarter of your investment, you probably shouldn’t have greater than 60% of your money invested in equities (based on the historical performance of a well-diversified, balanced portfolio).
Consider the following guidelines—a gut-check test—for aligning your maximum tolerable loss with a historically appropriate level of maximum exposure to stock-based investments:
Take this analysis from the theoretical into the practical by using the actual dollar amounts applicable to you. For instance, if you have $1 million nest egg, imagine what it would be like to lose $250,000, not 25%.
This is, of course, not the only factor to consider when developing your portfolio’s asset allocation. You should also gauge your time horizon and the return necessary to meet your goals. But determining how much of your portfolio you’re capable of losing without abandoning your long-term investment plans is the most important factor, because an abandoned plan is as good as no plan.
When you’ve proactively established a portfolio designed to take advantage of the market’s upside—but balanced with enough conservative fixed-income exposure to weather the market’s downside—you can stop worrying about if, how and when Greece is going to default.
You can also stop worrying about the impact it will have on the broader markets and your portfolio. Although it will never be pleasant to lose money, you will be able to see the inevitable market downswings as organic opportunities to buy low and sell high; that is, to rebalance.
So, should you make any changes to your portfolio in response to this newest round of uncertainty from Greece? Well, if you already have a deliberate investment plan in place—a proactive portfolio customized to your willingness, ability and need to assume uncertainty risk—the answer is “no.” If markets are jolted by a meaningful loss, or we see a correction (or worse), you’ll certainly have opportunities to rebalance, but Greece shouldn’t change your plan.
If you don’t have a plan in place, then this particular scare is as good as any other to serve as a reminder to do what you should’ve done in the first place. Create a plan.
Investing is the science of uncertainty management. So be honest with yourself. How much uncertainty can you handle?
I’m a speaker, author, wealth advisor and director of personal finance for Buckingham and the BAM Alliance. Connect with me on Twitter, Google+, and click HERE to receive my weekly post via email.