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One's net worth is an easy number to calculate (i.e., assets minus liabilities), and having obtained it, the number is easy to compare to the net worth reported by others to establish one's ranking. That ranking is good for bragging that “mine is bigger than yours”. But that ranking can't be spent at the grocery store or the fuel pump. So, it is a mostly meaningless exercise, the equivalent of ranking oneself by shoe size or shirt size (though probably not dress size, where petite is genuinely prestigious. LOL) But the number that should matter, as people do their financial planing, is sustainability.

How many adverse scenarios can their income streams sustain before intolerable hardship or total financial destruction ensue?

Thus, what matters isn't the quantity of assets one might own, but their quality with respect to their “robustness”, which is a term I need to define. As traders use the term and apply it to a trading system, what they mean by “robustness” is that the decision rules are limited in number and their parameters fairly generic. The purpose of a robust system is the ability to obtain good-enough results across a wide variety of markets and market conditions. The opposite of a robust system is one that has been fine-tuned –-or, worse, curve-fitted-- to a very precise set of conditions. When those conditions exist, the systems obtains maximal, top-of-the-ranking results. But when those conditions weaken or disappear, a non-robust system loses money or completely self-destructs.

How might portfolio robustness be measured? How easy is it to obtain?

A large quantity of low-robust assets can substitute for a lesser quantity of high-robust assets. But the realities of investing suggest that a typical portfolio will be made up of a combination of each. Thus, the typical portfolio will be bigger than ideal efficiency would require. Call that excess a safety margin, or a normal margin of error, and get used to the fact it will exist. The planning task then becomes that of determining sustainability, which involves a forecasting decision: how grim will the future be? That is unknowable, right? Therefore, a fall-back strategy has to be employed in which risk is defined as the combination of the likelihood of an event and the magnitude of an event. Markets fluctuate. Therefore, investment returns will fluctuate. Historical patterns can be guidelines by which to estimate the likelihood and magnitude of future events, which is simply Standard Theory as preached by Modern Portfolio theorists. But experienced traders –-a group that investors dismiss as risk-seekers-- live by this motto: “Your worst draw down is yet to come.” Thus, it is traders who are the more risk-adverse of the two, because they structure their activities so as to ensure sustainability. It is average investors, as they hope for the repeat of benign conditions, who are being reckless. And it is “average” Americans, as they and their government spend borrowed money, who are hoping they will be able to buy their way out of the financial hole they are digging. In the recent pastn such a strategy has worked, or at least it hasn't blown up beyond recoverability. But a mere lifetime ago, our parents lived through a severe depression of world-wide scope. The feckless bet is that such a thing will never happen again. The realistic bet is that it will, and quite soon.

How much robustness you require of your portfolio before you feel comfortable with it will be an individual decision that only each investor can make for her or himself.

Charlie
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