How to Apply Chaos Theory to Financial Advice
Source: FAIQ, Feb. 11, 2019
GARRETT KEYES, REPORTER, FINANCIAL ADVISOR IQ: Hello, my name's Garrett Keyes. I'm a reporter for Financial Advisor IQ. I'm here today at the Investment Institute Conference in New York City with Jim Sandidge the principal of the Sandidge Group. Jim, could you explain what chaos theory is?
JIM SANDIDGE, PRINCIPAL, THE SANDIDGE GROUP: Chaos theory is a branch of mathematics that deals with non-linear relationships. The father of chaos, Edward Lorenz, was doing some work late 1950s, early '60s, and that's kind of where they traced it to. He's considered the father, and he did some work that was very revolutionary, compared to classical physics, challenged many of the underlying assumptions about classical physics
GARRETT KEYES: Do financial advisors need to approach retirement income in a different way than what they normally have done so far?
JIM SANDIDGE: Yes, it is completely different discipline from accumulating wealth, and the reason why is because wealth accumulation is a linear process. Distributing wealth is a non-linear process. Because it's non-linear, the laws of chaos theory apply to retirement income, not to pre-retirement.
GARRETT KEYES: For a financial advisor, when they're looking at retirement income, what about retirement income is non-linear?
JIM SANDIDGE: Well, there are three key relationships that they should focus on. The first one is the relationship between fees and wealth. When you're accumulating wealth, if you pay a lower fee than I do -- for example, if you pay 25 basis points less than I do over 25 years, you'll finish with about 6% more principal -- very predictable. When you're distributing wealth, that doesn't apply. You could actually pay a lower fee, and I can end up with more principal than you because of the other factors that are involved.
GARRETT KEYES: For advisors I guess trying to apply chaos theory to their approach to retirement income, what exactly should they do to bring that into their ideas if it's something they haven't had before?
JIM SANDIDGE: Yeah, there are four key concepts of chaos that I apply. The first one is predictability or non-predictability. You can predict accumulation portfolios if you know the present value. You can forecast the future value.
Once you start taking distributions out of the portfolio, that no longer applies. You can't tell what your future value will be based on the current value and the other variables. So that's one thing I think is different.
Second is the most well-known concept of chaos is the butterfly effect. It's the idea that a small change to an input can lead to a big change in the output. Again, going to wealth accumulation, small changes don't have big impacts. If you're shooting for an 8% return to get to a certain account value and you earn 7.8%, it's not exactly what you're shooting for. But 7.8% is pretty close, and you're going to be in the neighborhood.
Again, that's very different post-retirement. Very small changes can have a very surprising impact on the long-term values. So it could be small changes to fees or the risk allocation. And anything at all it's a variable can really change the output a lot.
The third factor is averages. Averages mask non-linearity. So accumulating wealth, you can forecast, again, based on your average return: If I earn "X" over the next 10 years, I'll have "X." But averages mask non-linearity. Again, they don't apply post-retirement, so you cannot manage to an average.
What you find is averages are about the long term. Chaos is much more about the short term -- much more about the journey than it is the destination.
And then the fourth factor is nonlinear thinking. We are wired naturally to think in a linear manner. That works great for a linear problem, like wealth accumulation. But again, once you start taking a distribution, it converts that into a non-linear process and requires non-linear thinking -- outside the box thinking or creative thinking, if you will.
GARRETT KEYES: So what do advisors do? If humans are wired to think in a linear manner, what do advisors do to think in a non-linear manner?
JIM SANDIDGE: Yeah, that's a great question. The best defense against any behavioral bias is an awareness of the bias, to begin with. So that's the first thing.
Second is the genesis of creative insight is challenging assumptions. So whatever assumptions you may have made about any kind of process, but specifically accumulating wealth, you can't assume that earning a higher return will give you more wealth post-retirement. So you want to challenge all the assumptions that you can think of. And again, just be aware of the biases that can affect you.
GARRETT KEYES: I guess lastly what would you say the dangers are of approaching this non-linear problem of retirement income with the linear thinking?
JIM SANDIDGE: When you're accumulating wealth, you've always been able to count on time to erase any mistakes or inefficiencies. You've always been able to recover from every bad market. That's no longer the case. You can't count on time.
As I said, the rules change completely. It's a whole different game. So you can't count on what worked previously, previous rules, previous strategies, things like that. So that's first and foremost is just the idea that it makes for a much safer portfolio for the client.
GARRETT KEYES: If an advisor kind of does wrap their mind around this different way of thinking, what are the benefits that could be seen from this different approach?
JIM SANDIDGE: Well, I think certainly, first and foremost for the client, it makes for a much safer portfolio. You're trying to solve a non-linear process with linear thinking -- stuff that [for when] we're accumulating wealth -- it's not only inefficient but potentially dangerous post-retirement. So again, most importantly, it makes for a very much safer portfolio for clients.
Second, from a branding perspective for the advisor: If they can present themselves as more knowledgeable about retirement income because they are a non-linear thinker -- psychologists have shown that people like innovation, not just innovation and features and benefits but innovation in and of itself. So original thinkers are highly regarded in our society -- the people we think of as creative geniuses. Think about it -- the Einsteins of the world are the ones who had the new idea, the original idea. So advisors who can present themselves as this type of an original thinker with retirement income makes all of their ideas more valuable
GARRETT KEYES: Thanks for speaking to me today, Jim.
JIM SANDIDGE: Thank you.