The state of financial literacy in our country is in poor condition -- very poor condition. So when the average American sits down with a financial advisor, and that financial advisor plugs in investment returns based on the market's historical average, we don't think twice.

That's a huge mistake, according to Nassim Nicholas Taleb -- a former trader, current best-selling author, and distinguished professor of risk engineering at NYU's Tandon School of Engineering. Recently, I sat down with Taleb to talk about how we should be considering stock returns when we put together our own financial plans.

Cartoon of profit chart graph arrow nearly falling on stick figure wearing a tie

A sudden drop can change everything. Image source: Getty Images.

On automatically assuming you'll get the market's historical annual return of 9.2% per year

Let me explain the foundation of the problem: All of these analysts who look at you and the stock market assume that if you invest in the stock market, you'll replicate the performance of the stock market.

The problem is, if you ever have an "uncle" point -- where you have to liquidate -- then your return will not be the stock market's. It will be the returns to your "uncle" point -- which is negative.

In other words: the market can have a positive expected return, and you have a negative expected return.

It's not hard to find third-party evidence to back up this assertion. Foolish colleague Matthew Frankel -- using data from Dalbar's Quantitative Analysis of Investor Behavior -- showed, in 2015, the average investor's returns were terrible.

Chart showing market's returns versus the individual investor's returns.

Data source: Dalbar. Returns calculated by multiplying CAGR by given number of years.

This happens for lots of reasons. Frankel cites the herding behavior of buying high and selling low as a key culprit. Indeed, it's easy to say you'll be greedy when others are fearful -- and visa versa -- but difficult to actually do it.

On "uncle" points and forced liquidation

As an investor you need to think about it in these terms: No investor knows what's going to happen to him or her in the future.

The market may deliver whatever people claim it will deliver. But if you have a drop in the market that may force you to liquidate -- particularly a drop in the market that may correlate with your loss of business elsewhere -- then, automatically, your returns will be the returns from today until that drop in the market. It de-correlates from the market.

In his other writings, Taleb throws in other examples of "uncle" points, like an unexpected divorce, health problems, and the like. The point is simple: You are more likely to liquidate your position -- whether out of fear or necessity -- when the market drops. This will ruin your returns.

How to deal with this reality

If you have an investment as an institutional investor ... and you don't have a tail hedge protection, then your returns are virtually going to be zero -- over the long run.

If you have tail hedge protection, then your return will be higher than the market. Because you can get more aggressive during the times when people sell.

This is not well understood. My strategies have been to overload with tail options...and not because you get a good pay-off if the market collapses. It's because it allows you to buy when nobody has dry powder.

Unfortunately, many of the strategies that Taleb uses are sophisticated and difficult for the individual investor to enact.

Taleb argues that just keeping a lot of cash on the sidelines isn't necessarily the best strategy, either: "The risk of having a lot of cash is that if the market rallies -- for the individual investor it doesn't work well -- you have all this cash, you missed on a big move."

That leaves just one primary approach for individual investors, which I've already written about before: the barbell approach, or, "to have a smaller amount allocated to the most volatile things, rather than a larger amount allocated to medium-volatile things."

An alternative view

As a site primarily for individual investors, I was left wondering what to do about Taleb's justified fear of just holding cash. The phrase I kept coming back to was, "it allows you to buy when nobody has dry powder."  Dry powder is the key -- it gives you options when [stuff] hits the fan. The most satisfying solution I could find was fleshed out by former Fool Morgan Housel a few years back.

Morgan wrote a number of interesting articles on this conundrum. In essence, it was about reserving a standard percent of your portfolio in cash -- but not too much -- and only deploying it when the market fell by a certain amount.

The key: protect your downside

One of the most fundamental tenets I've gained from Taleb's writing is that -- no matter how remote the possibilities seem -- you always need to be paranoid about protecting yourself against highly unlikely misfortunes. 

If you're looking for the simplest solution to not having to liquidate when a crash occurs, here are a few very simple steps that will markedly improve your performance:

    • Make sure you have sufficient insurance (health, vision, dental, disability, etc.) so that out-of-pocket expenses are capped at an amount you can cover in a moment's notice.
    • Keep an emergency fund on hand that can provide for your family for three to six months without any form of income.
    • Live below your means!
    • Only check your portfolio quarterly -- or develop the stomach for big swings.

When you have this protection, your "uncle points" are far less likely to hit, and you could actually end up gaining from market downturns in the long run.