On Uncertainty in Investing

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As part of the Observatory (our financial planning process), our investors unsurprisingly end up with, well, investments. These allocations are based on client need, desire, and ability to take risk, and the allocations tend not to change too frequently over time. A client’s portfolio here is not based on an assumption of all sunshine and rainbows, but rather a review of history, including market declines in March of 2020, 2008, 2000, 1987, and even more obscure disturbances like the events of 1997 and 1937. 

In our Observatory process, we don’t model any sort of attempt to predict or avoid these events. Instead, we model a disciplined approach of staying invested and taking opportunities to rebalance into equity markets after drawdowns. This approach has worked extremely well in the past, and our view is that it will continue to work in the future. Nevertheless, there’s a fundamental human desire to avoid risk at all costs, especially when things seem particularly risky, and there are always a few clients eager to “get defensive until the uncertainty subsides” in every market environment.

For our investors, we believe we preemptively position defensively through allocations to short and intermediate term bonds. Those bonds aren’t there for the good times- in fact, they are a drag on performance when stock markets are strong. Bonds shine after a serious stock market downturn when they possibly contribute some total return. More importantly, they serve as a source of cash to rebalance into equities (just when equities have declined and become more attractively priced). We believe selling stocks and adding to bond allocations or going to all cash after a big market decline is the worst time to do so.

I was listening to the radio recently, and the host asked a guest, “…but what’s the point of economic modeling at a time of such great uncertainty as this?”  I couldn’t help but laugh out loud. The host was referring to the Ukraine invasion, and he seemed to be implying that a forecast made the day before Russia invaded would be much more appropriate than one made the day after since so much “uncertainty” would be introduced by the conflict. I laughed because all forecasts are equally based on ex-anteinformation and therefore don’t incorporate the unknowable future. Forecasts made confidently when things seem certain are likely the worst forecasts of all! The situation in Ukraine has become more certain today than at any time in the last decade or so. The greatest unknown— the question of whether Russia would dare a full scale invasion of Ukraine— is uncertain no longer.

Stepping back, when in the past was there not uncertainty? Markets have performed exceptionally well for many decades, but we know that only because of the prescience of hindsight. Following the 2008 financial crisis, the US stock market bottomed out quickly in March of 2009 and has provided extremely attractive returns ever since, but we sure didn’t know that was going to happen back then. There were concerns that banks would fail, cash would stop coming out of ATMs, and life as we know it would grind to a halt. The last decade was an exceptional one for investors, but who could have credibly predicted that in 2010?

As Yogi Berra said, it’s tough to make predictions, especially about the future. We are certain that the future will contain some difficult times, and that’s ok. If we devote all our efforts to avoiding the bad times, we’ll miss the good times too. If history is any guide, the good times will continue to be good enough to offset the bad in the years and decades to come— but only if you stay invested.

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