When investing, there is little that can be known with certainty. Returns are not guaranteed, even over the long term. Future returns depend on the nature of the starting point, the path taken, and where you end up. Bertrand Russell said: “What men really want is not knowledge but certainty”. When investing uncertainty is the only thing we can be sure of.
But while nothing is certain, we do know that some outcomes or events are more likely to occur than others. However there is a danger in focusing only on things that are more likely to occur and ignoring distinctive but remote possibilities.
As Nassim Taleb foreshadowed, the events of last year illustrate the overwhelming importance of a few seemingly remote, extreme events. These are events that almost certainly won’t happen, but if they do it’s really going to matter.
Investors often find it hard to imagine investment outcomes dramatically different from those they have already experienced. The collective investment herd always thinks it knows what its doing and the longer it runs with an idea the more compelling it becomes. Investors who focus on the fundamentals can find that the market persists in ignoring them for extended periods of time.
While it can be difficult to sustain, being contrarian ultimately achieves better investment returns. This involves buying unloved (cheap) assets and selling (expensive) ones that everyone wants. But to do this successfully you have to be prepared to stand back from the market and accept lower short term returns – and sometimes the short term can last for quite some time.
Here is an observation made by MLC in December, 2004, well before the sub-prime crisis: “It is difficult to envisage an adjustment scenario that does not involve some significant economic pain…This situation could be of very long duration – making it increasingly difficult to untangle without a crisis.”
Today these comments may look remarkably prescient. But they were made back in December 2004. Clearly, benefiting from such insight can require patience.
In the short term, market returns can be inconsistent with the underlying investment fundamentals. Ultimately though the fundamentals will drive investment returns. For example equity returns depend on company earnings, which depend on economic growth. But how those economic fundamentals vary – and how that in turn flows through to earnings and the value the market places on those earnings – are all uncertain. There are layers of complexity.
A transparent approach to building understanding of what could happen is to consider a range of potential scenarios and to stress test a portfolio. This is the approach MLC uses and it provides a robust basis for medium term asset allocation adjustment. Perhaps most importantly it recognises risk, like returns, varies through time. And that risk is sometimes high and it is right to do something about it.
The credit crisis provided a clear demonstration of the importance of risk. The real risk investors face is not volatility of returns. It is the risk that markets do not deliver the returns that investors require. To achieve a better investment outcome – which ultimately means higher returns – we need to be patient and value risk control as much as we value returns.
Susan Gosling is investment manager at MLC
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