It is often said that death is the only certainty. If that is true, then the concept of certainty is the only thing that ultimately remains alive. Before your head starts to hurt, this article is not about life and death, but rather the lack of certainty that now prevails in the world of investing. In recent times investors have bemoaned the level of uncertainty as markets move from one crisis to another and policymakers change the rules of the game in order to attempt to shore up the markets. At least in financial terms, the concept of certainty is dead and investors need to adjust their thinking to this reality. There was a time when one could have identified a most likely outcome and invest towards that outcome.
Markets were fairly stable, there was an element of predictability to the overall trend and a stock moving by more than half a per cent in a day would be an extraordinary event. Today, that is no longer the case. In the current climate the general rule is an absence of established rules. Companies are being bailed out like never before and central banks are providing liquidity in ways and to levels that have never been seen before. Policymakers are drafting rule changes that are so complicated, the objective is often unclear. Contracts are becoming less sacrosanct and there is a trend towards expropriation of private assets at a governmental level.
How all these issues will combine together in terms of producing an investment outcome is largely unknown, but the combination of these market externalities has resulted in extreme volatility, unprecedented market movements and often times results that defy logic.
Risk and volatility
The question of risk, uncertainty and volatility is often seen as one issue. However, there are subtle differences and these differences often lead to different expectations between investors and portfolio managers. The basis upon which most financial professionals structure a portfolio is defined in a concept known as modern portfolio theory. This theory suggests that risk is measured in terms of volatility. Volatility, in turn, is measured using a calculation called the standard deviation. The objective is to show how much the return on an investment varies from the average return over a defined period of time. Another statistical measure that is often referenced is known as beta which is the price volatility of an investment when compared to the market as a whole. A high beta stock is considered to be more risky because it is more volatile than the overall market. Likewise, a stock with a higher standard deviation is also considered to be more risky.
From the perspective of a portfolio manager, risk is undertaking an investment where the distribution of outcome and probabilities associated with those outcomes are known and then trying to position the portfolio so that the next series of market moves will provide a positive investment outcome. For example, if a market is rising, a portfolio manager will seek out higher beta stocks because these stocks are likely to rise more than the market, which benefits the portfolio. Similarly, if a market is falling, the manager will shift into low beta stocks as these are likely to fall less than the market. These shifts and the different asset allocations associated with these shifts represent some of the basics of active portfolio management.
Losing money
While this is the methodology of the average portfolio manager, ask the average investor about risk and you get a completely different response. For the typical investor risk is simply about losing money. If one guaranteed a particular outcome and that outcome is in their favour, then the typical investor is comfortable. So long as there is a risk of loss, then the response is often "no thanks." The typical investor views risk as uncertainty as opposed to volatility. This is because they often lack the information that is possessed by their portfolio manager. For the typical investor, the probability distributions and statistical measures identified above are unknown hence the uncertainty. The portfolio manager managing the investor's funds is able to use the data to assess likely outcomes and so defines risk as volatility. These differing perspectives often lead to confusion in terms of how funds are managed.
Given the perspectives identified above when a market is falling, the typical investor will simply want to get out. The objective is to sell so as to remove all potential for losses. However, in these circumstances, the typical portfolio manager will be seeking to remain invested, but to shift the portfolio to stocks that are likely to fall less than the overall market. From the perspective of the investment manager, the objective is to always have a position in the market. This is because it is impossible to perfectly time the market and "a rising tide carries all boats." When, therefore, a market rebound becomes clear, even a low beta stock should still generate some measure of positive return over the period of the rebound. The portfolio manager may underperform the market by being in low beta stocks, but the portfolio will still be better off than being in cash. The point to appreciate is that a trend only becomes a trend when analysed after the fact. The idea of remaining invested and adopting techniques through which one can do so with a lower risk profile is based on the fact that trend is your friend, but a trend is only established with the passage of time.
Dilemma: Buy, sell, hold?
If one takes the view of the typical investor and steps out of the market and then back in based on the trend, then over time one would find that the majority of selling would take place near the market bottom and the majority of buying would take place near the market top. The reason for this has already been identified in that the trend is only determined after the fact. Therefore, an investor seeking to ensure that they do not lose money will most likely seek to put money in the market when an uptrend is confirmed. By the time that happens, the easy money has already been made and the investor becomes one of the last buyers in the rally. Those that were in the market from the beginning of the rally (the professional investor) would be the ones selling to the "new" investors in the process booking profits for their portfolio. In today's climate, it is not just issues around stock performance that one has to contend with, but a host of other issues, from geopolitical, political, regulatory, and outlier events, which have become much more common place in recent time.
It may surprise you, but the secret to success in this environment is to stay invested. The absence of certainty makes the market timing game even more taxing than in a more normal environment. Recognise that despite the economic uncertainty in the United States, its stock market has rallied by more than 100 per cent since March 2009. Also, despite the negative growth in the T&T economy, the local stock market was up more than 20 per cent last year. Why bother to try to predict the market? It is often an exercise in futility. It is much better to establish how much of your funds you would like to allocate to investing in stocks and stay the course. So what if you don't think you need to be invested in stocks at all? If that is the case, then I am certain that you are either already wealthy, or will have to save more of your income or work longer for the rest of your life.
The choice is yours.
Ian Narine is a broker registered
with the Securities and
Exchange Commission.
