04 November 2020

    Certainty in an uncertain World

    In what has been a year of uncertainty, now familiar fears bubbled back to the surface in October dragging down markets. Investing is an exercise in managing this uncertainty, seeing through it and making sound long term decisions. Often the best way to do that is not to focus on what is uncertain but rather on those things you can be more certain of. 

    Human beings hate uncertainty. A lot.

    This month, after a period of relative calm, uncertainty once again gripped markets with share markets around the world falling. The New Zealand share market was an exception to this but even here returns tailed off into month end.  Not many treats, too many tricks were the flavour of the Halloween month.

    A 2016 study by de Berker et al in Nature Communications highlights just how much we hate uncertainty. The study, which gave its participants electric shocks if they overturned a virtual rock that was hiding a snake in a video game, concluded that not only is uncertainty stressful, but that it is even more stressful than knowing something bad is definitely going to happen. In this case participants stress levels peaked as uncertainty was around 50%, i.e. the point of maximum uncertainty. They were less stressed even if the game had been rigged to deliver a much higher ratio of snakes to empty rocks, therefore an electric shock was more likely. Knowing you were going to get a shock was less stressful than being uncertain if you were.

    It’s no wonder that in times of uncertainty markets tend to sell off, even if history suggests at least some of the concerns will be transient. Like the survey participants we would rather the certainty of selling our shares into a down market than face the uncertainty of a market that could worsen, or of course could get better.  

    There was a laundry list of concerns assailing investors this month - US elections, new COVID lockdowns, the will they/won’t they economic stimulus packages and threats of regulation for US tech stocks.

    Uncertainty is always present in financial markets. Sometimes it’s at the forefront, sometimes it recedes to the background. Either way it’s always there. How we manage uncertainty is key to building successful investment outcomes and to building your wealth.

    I try, as Charlie Munger, Warren Buffet’s lesser known, but equally impressive offsider, advises, to invert the problem. Rather than focus on the uncertain, focus on what we can be more certain about and base decisions around that.

    While finding the truly certain in markets is hard, there are few things we can have confidence about especially if we can exercise the most important investment skill of all – patience.

    1. Quality works - investing in quality companies is at the core of the Fisher Funds STEEPP investment process. High quality companies with great management, little or no debt, high barriers to entry to withstand competition and the ability to grow earnings confer, in our opinion, real advantages to your portfolio, both reducing risk and enhancing long term returns.

    The numbers are stark. In the last 10 sell offs of 10% or more (based on the MSCI World Index covering periods since 1982) quality companies outperformed the broad market by 4.1% on average. This reduces portfolio risk.

    This did not come at the cost of returns through the cycle. Over the last 34 years that MSCI, a compiler of stock market returns, have run their “quality” index there has not been a ten year period where quality stocks have done worse than the market. That’s not certainty but it helps me sleep at night.

    2. Politics is short term noise – Charles Schwab strategist, Liz Ann Sonders, said it best “if anything the economy and the stock market matter more for politics than politics matter for the economy.” In her work she went back over 30 US electoral cycles and concluded that there was little correlation between the politics of the winner and subsequent economic and market returns.   

    To borrow from Macbeth politics is “but a walking shadow; a poor player, that struts and frets his hour upon the stage, and then is heard no more: it is a tale told by an idiot, full of sound and fury, signifying nothing.” Ignoring it will most likely add value to your portfolio.

    3. Strategy trumps tactics – uncertainty makes it very tempting to ignore long run portfolio strategy and to turn to tactics like trying to time to market, hedge exposures or somehow avoid the short term stress of an uncertain environment. 

    Getting tactics right is very hard to do. If you are wrong and miss even a handful of the good days in the market it materially impacts long run returns. The 2020 JP Morgan Retirement guide highlighted that being out of the market, measured in this case by the S&P500, for the ten best days over the past 20 years would see your annualised return plummet from 6.1%pa to a miserly 2.4%pa. What’s more 6 of those ten best days were within two weeks of the ten worst days.

    Tactics are highly uncertain. The long run benefit of investing in shares is far more certain.

    The last couple of weeks have been uncertain, but by focussing on what we can control and by having a clear investment strategy we can manage our fear of the uncertain and get on with the real task of building long term wealth. And hopefully we can avoid some of those electric shocks!