Why Does Protecting Wealth Come First?
Ironically, the best way to build wealth may very well be to focus on protecting it first.
In the very first Investment Insights – in the very first sentence, in fact – I described the column as “dedicated to the practice of protecting and building wealth.” Intrepid readers who clicked the footnote learned the following about the preceding quote:
The purpose of this column, an apologia of sorts, is to fulfill that concluding promise.
The writer in me, with a much simpler task, will explain himself first. The sequencing of the phrase seems backward. How can you protect wealth if you haven’t built it first? With no wealth, what is there to protect? While the sentence is certainly understandable, the apparent typo has the effect of a stubbed toe. It interrupts the reader’s path through the paragraph, jarring their attention from the task at hand. This is bad writing.
The investor in me, facing a greater challenge, must now attempt to justify the bother. There are two reasons why the phrase cannot be written any other way, each equally important. First, identifying and understanding risks is one of the most important factors, if not the most important factor, to building wealth. Second, you will miss or, just as bad, misunderstand risks without the proper approach to building wealth. Each deserves further elaboration. Let us begin with the latter.
Why will you miss risks without the proper approach? This seems like a financial problem, but the real reason is actually multidisciplinary. You need the proper approach to identify and understand risks because what you aim for determines what you see. “Protect” must come before “build” to explicitly ensure the correct aim. Doing so creates a “what can go wrong?” point of view rather than the inverse, “what can go right?” Just a single word separates the two, but that single word changes everything.
Cognitively speaking, it is easy to miss things that you are not deliberately looking for. The world is rich and dense with information. Yet the human brain, as amazing as it is, cannot pay attention to everything everywhere all at once. 1 For example, watch this video.
(long pause while you watch the video…)
The video is part of a larger body of academic research on attention. 2 The field includes phenomena such as selective attention (suppressing irrelevant or distracting information), change blindness (change to a stimulus unnoticed by the observer) 3 and inattention blindness (failure to see a stimulus, as you now know).
As the research demonstrates, we would be overwhelmed with information if we did not filter. Unfortunately, much filtering happens before information reaches the level of conscious thought (or else, by definition, it would not have been filtered). As a result, relatively little unsought information reaches the level of awareness. 4
The corollary to our inability to notice things we are not looking for is our tendency to more frequently notice things that we are looking for. In subconsciously filtering out irrelevant information, our brains are also filtering for relevant information. When you’ve got something on your mind, you tend to notice it more often. This is called frequency illusion (or Baader-Meinhof Phenomenon or frequency bias), which describes a tendency to notice something more often after noticing it for the first time. You may have even noticed this phenomenon in your own life. If you haven’t, I predict that you soon will now that you have been introduced to it. 5
Understanding now that there is no conscious perception without deliberate attention, we can return to the discipline of finance. If you aren’t explicitly looking for risks, you will miss all but those largest and most obvious. And it is precisely those types of risks, small and hidden, that create the largest obstacle to building wealth. Large and obvious risks are quickly and efficiently priced into financial assets, such that the expected return rises to a sufficiently compensatory level. However, financial asset prices often do not properly compensate investors for small and hidden risks, particularly when they one day become large and obvious. This is a significant danger to those seeking to build wealth. By explicitly looking for risks – by using your cognitive biases to your advantage for a change – you can reduce both the frequency and magnitude of such possibilities.
Turning now to the first reason above, why is it important to identify and understand risks? Answering that question requires introducing a new concept: compounding. Compounding is when you earn returns on the returns of investments, 6 building wealth in an exponential fashion over time. Without compounding, wealth builds much more slowly in a linear manner over time. Steady, uninterrupted compounding, over time, is the surest way to build long-term wealth.
It is important to see risks because risks interrupt compounding. When unforeseen risks cause losses, efforts to build wealth are set back until the value of your investments recovers. This can take some time, as the gain necessary to do so is larger than the initial loss. For example, losing 25% of your money requires a 33% gain just to get back to even. It gets worse though. The larger the loss, the more challenging it gets to recover. Losing 50% requires a 100% gain. Losing 75% requires a 300% gain. This is the mathematical rationale for seeing risks. Building wealth successfully becomes much easier if large mistakes can be avoided.
There is also a psychological rationale for seeing risks. Risks can create volatility 7 in the value of your wealth over time, resulting in periods of uncertainty that can be difficult to endure. The stress experienced during these periods can lead to poor decision-making and counterproductive behavior, such as selling some or all of your investments at a temporarily depressed price just to relieve the anxiety. Doing so interrupts compounding and severely damages efforts to build wealth.
Before concluding, it is worth exploring the other side to the argument posed in this column. Why is the properly sequenced phrasing, building and protecting wealth, actually worse? Because ignoring or deprioritizing risk (protecting) in favor of growth (building) fundamentally changes the approach. Over time this approach, knowingly, but more importantly also unknowingly, takes more and more risk in pursuit of faster and faster growth. This can work, for a period of time at least.
Often though, initial success reduces the desire to properly assess known risks and proactively identify new risks. 8 If, or more likely when, such risks materialize, investments that have risen far and fast fall just as quickly, and sometimes fatally. The approach that takes great risks, whether explicit or perhaps un- or underappreciated, to build great wealth is simply not well suited for protecting that same wealth. In reality, such an approach is inherently unstable and will eventually collapse. 9
Having looked at the phrase both ways now, protect and build, build and protect, it is important to note that neither alternative should be interpreted as an ‘either or’ proposition. Long-term success requires simultaneously protecting wealth and building wealth. The only debate concerns which should have precedence over the other.
While each term is important, perhaps even equally important, explicitly prioritizing one over the other prevents that choice from being made for you subconsciously based on your ability, experience, perspective and temperament. As outlined over the preceding 1,300+ words, I believe that the best choice is to focus your attention first on risk (protect), then, after a thorough consideration of what could go wrong, turn your focus to growth (build) and what could go right. Ironically, the best way to build wealth may very well be to focus on protecting it first.
Thoughts? I would love to hear them. Email me at firstname.lastname@example.org.
Written By Keith R. Schicker, CFA
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It can, however, pay attention to Everything Everywhere All at Once. I haven’t seen it yet. I hear it is a very good movie, though A24 films aren’t always for everybody.↩
Don’t worry if you failed the test (and I don’t mean failed in the sense that you counted an incorrect number of passes; if you watched to the end you know what I mean), 58% of observers in the initial study did so as well. I failed the test my first time as well, so you are in esteemed company.↩
If the last video peaked your curiosity, here is an excerpt from a study on change blindness. ↩
However, some particularly meaningful unsought stimuli do reach the level of awareness though. ↩
Real life example: I was driving with a friend who said he likes the way non-metallic finishes look on a car. After hearing that comment, I started noticing cars like this everywhere even though this is a relatively recent trend and only a small percent of cars on the road would have this type of finish. You may start seeing them everywhere as well now.↩
And returns on the returns on the returns of investments. And returns on the returns on the returns on the returns of investments. And so on and so on… Compounding has many implications for protecting and building wealth and will be the topic of a future column. ↩
In actuality, volatility is sometimes a risk and sometimes an opportunity. The difference is nuanced and dependent on many factors. This will be the topic of a future column.↩
The investment is working and you are making money, so why bother? That is an all-too-human response that must be guarded against.↩
As a matter of fact, the very last Investment Insights was about this very dynamic.↩