Humans dislike uncertainty. We seek explanations for why something has happened. Then we use these ‘reasons’ to extrapolate what is going to happen.
If these shortcuts are relationships that have held over very long periods of time, they can be useful. However, all too often their explanatory power is suspect at best and gives us a false sense of security about the future.
This means that we are often surprised and disappointed that things did not turn out as hoped. ‘How could we be wrong?’. The good news is that there is a great antidote to this hardwiring of the brain. Rather than trying to predict the future, especially the short term, it can be helpful – and even liberating – to embrace the fact that the future is unknown and plan for different scenarios.
Let me give you an example of one area that is perplexing investors. Last week, my CIO Office had a meeting with a geopolitical specialist who works for a fund manager. We covered three topics that are, according to the analyst, top of mind in Washington DC: the Russia-Ukraine conflict, US-China relations and the impact of climate change on geopolitical instability.
It was not the most heart-warming discussion I have ever had. The analyst’s conclusions were threefold:
First, the risk of a Russian nuclear deployment was higher than appreciated by most market participants – thankfully far from a central scenario.
Second, while the US and China are trying to reduce their economic interdependency in a mutually amicable way, this is unlikely to be a smooth process. The risks are exacerbated with the lines of communication between the two superpowers being tenuous at best.
Third, severe droughts around the Equator are just a matter of time. This will lead to very significant geopolitical risks that are difficult to fathom.
Wow! I told you it was not for the faint hearted. Anybody want to build your retirement home in Greenland (or according to the analyst’s preference, Vermont)?
Over-thinking on risk factors
What should an investor do with these views? The temptation is to do absolutely nothing. Faced with extraordinarily high levels of uncertainty and complexity, the risk is we fall into analysis paralysis and suspend our investment plans.
Alternatively, don’t these views mean we should reduce our equity allocation further? It is certainly tempting to add the above geopolitical analysis into the mix to make our bearish equity market story even more compelling (our real reason to be bearish is we believe the US economy is heading towards a recession).
Hang on a minute. If we are worried about a sharp escalation in tensions between the US and China, what can history tell us? An obvious incident to look at would be the Cuba missile crisis in 1962.
Sure enough, if you look at the chart of the US S&P500 index, you will be unsurprised to see that the stock market fell over 20 per cent in 1962. However, if you cross-reference the dates, then you will also note the low of the US stock market was in June, well before a US spy plane took the first picture of newly-installed missile installations in Cuba on October 14. As an aside, the market went on to make new highs in 1963 and never saw the 1962 lows again. Therefore, even if you told me what was going to happen, we probably would have made a bad investment decision had we sold equities going into the event.
The stock market bottomed less than 24 hours after President Kennedy publicly acknowledged this risk of a nuclear confrontation.
Go low on equity?
This answers a question we get all the time: given we expect another leg down in developed market equities, why do our recommended portfolios still have a significant equity allocation? The answer: nobody knows what is going to happen in the future.
We would never recommend having a zero allocation to global equities, even if we are concerned about the short-term outlook. Despite having a strong track-record of adding value over the past decade through our tactical asset class tilts, we have been (and can be) wrong from time to time. Betting against stock market gains is particularly risky given they outperform bonds around two-thirds of the time.
I would argue that acknowledging there are several potential outcomes is beneficial to an investor in two ways. First, it prevents you from investing based on one outcome, reducing the likelihood of having a very concentrated portfolio.
This reduces the risk of suffering extreme losses and becoming emotionally scarred to the extent that you: a) sell all your investments and 2) take months, or even years, to start investing again.
Second, by acknowledging that the world is complex and unpredictable, it helps mentally prepare you for the inevitable market fluctuations ahead. It also helps you plan potential changes you might make in the event of market sell-offs or strong rallies – for instance, adding on market weakness or trimming into irrational exuberance.