Switched Keys

It's hard to plan in the uncertainty that we have in congress today. At least, that's the common sentiment I keep hearing. The uncertainty, of course, is on things like whether or not the Bush tax cuts will be extended. Such was the uncertainty a year ago as well.

When people talk of financial planning, it is generally thought to refer to long-term plans, based on the benefits of certain types of investments and the related risks and rewards. In so doing, planners consider uncertainties over a period of decades. Currently, financial planning must deal with short-term uncertainty as well. In this uncertainty, waiting is one of the options that has been taken by many investors. While that is a valid choice, it may not be the only choice, or the only factor to consider. In this uncertainty, decisions can be made based on the things that are certain.

Many people will want to avoid as much uncertainty as possible, such as the future of capital gain rates. In that case, planning can weigh the benefits and losses on mostly certain events or conditions. For example, although there is pending legislation related to small business investments, the current laws still do provide many tax incentives that favor investing in small business, and the mood in Washington is to continue that motivation. Based on that, risks and rewards can be estimated.

If it is necessary to gamble on the uncertianties, gamble based on a set of probabilities. One of the techniques that some managers use is to chart the possible actions and then decide based on the relative risks and rewards. In so doing, individuals can select a path based on their investment personality. Maximin, Maximax, Laplace, and Minimax Regret are the terms I learn in school, but it might be easier to relate to pessimistic, optimistic, realist, and unregrettable frames of mind. In evaluating the choices, estimate the benefits and losses related to each using a chart and compare them.

If the client is optimistic, then the alternative with the best possible results would obviously be chosen. If the client is pessimistic, then the alternative with the best of the worst possible results. A realist would then select the alternative with the best average payoff (averaging the risk and reward) of any other. Finally, a clients might step up from pure pessimism to choose the alternative that has the least of the worst regrets. Although the mathematical model can be complicated to analyze and explain, it should be easy to identify the personality of the client and the risks are rewards can be easier to accept if they are calculated based on that knowledge.