Asset Allocation & Risk: The (im)patience of capital
Our two most valuable tools – our brains and time – should be harnessed to counter the potentially devastating consequences of our behavioural biases, says Bob Swarup
The world is an ugly and uncertain place these days. Asset prices are volatile. Newspapers are reporting a worsening economy and the growing worries of policy makers. The banks look weak and troubled, while rumours are flying about that significant capital raising may be needed. Job uncertainty is growing while wages are stagnant at best.
Central banks are looking to the monetary lever once more. Governments have unveiled important new job initiatives. Others propose ‘radical’ new plans to reignite growth. Political crossroads are looming and hard choices that affect us all will need to be made.
Around you, portfolios are recategorising their strategy rapidly from prescient market timing to buy, hold, and pray. The choice between a shrinking deficit and disaster will soon come down to a single, tense investment committee meeting this quarter.
Once asked to define time and space, the talented cosmologist John Wheeler noted: “Time is what prevents everything from happening at once. Space is what prevents everything from happening to me.”
Unwittingly, he also encapsulated beautifully both the importance of ego and the perception of time to our navigation of the financial universe. The role of human nature in financial markets is well established, having spawned a whole new field – behavioural finance.
It is a sign of our brevity of memory that each financial wobble is often viewed in isolation. It is also a consequence of the complex world we inhabit, especially the vast amounts of information confronting us at all times. The information is not always complete and the time to act is often insufficient.
The manifestation in volatile markets is an overriding human weakness: in life, there are urgent matters and then there are important matters. The two are not always the same.
When problems expose themselves, our myopic response is to deal with the urgent, and the important is often left unattended. In a crisis, staunching the wound takes precedence. Its healing is a matter to be considered tomorrow. Unfortunately, another crisis typically intervenes by then, and we put off deeper thought and tackling the underlying issues for another day.
Long-term planning and management require a long-term perspective. But in practice, our actions always have a horizon far shorter than the complexity of what we manage.
As a case in point, the problem of pensions funding at a macro level is a legacy of successive generations of policymakers grappling with this cognitive failure. And the fragilities in many portfolios similarly reflect the myopia enforced by the fact that there are too many variables, too many data points, too many uncertainties —in short, too much complexity in our environment—for our brains to take in. For most investors today, their time horizon falls somewhere between the next tick up or down in the markets and the next quarterly report.
But these little decisions today play out in big ways tomorrow. The lack of enough forward-thinking analysis and occasionally stepping back from the noise to think about the bigger picture means that we are always playing catch-up. By choosing to fight the urgent crisis today, we merely build a far more important crisis for the future.
In our minds, there is always time enough tomorrow for careful assessment and deeper planning. So, fragilities are papered over, not addressed. Risks are quantified, but thought and analysis often outsourced to models that bombard us with even more data to absorb.
And the greatest asset we have – patience – goes forgotten. It is time to reassert that quality of patience, both in thought and in action.
The world is a volatile place (again). Fears about global growth and the wheels coming off the Chinese economy have spooked investors. Commodities have collapsed. Emerging markets are in turmoil, while their debt burdens strain as the dollar strengthens. More than half of the main stock markets are in bear territory, while the ‘new normal’ is getting newer as negative yields spread and bonds price in a bearish outlook. All of these bear analysis and calls to action. But they also need to be carefully looked after, if we are not to be overwhelmed.
First, rather than merely opining and obsessing about the world, we should look to understand its impact on us and thereby distil priorities. To take time out to think about the bigger picture may seem a luxury but it is a necessity.
Second, we need to understand the greater trends playing out and their possible future paths, not over the next quarter but over the next year and the next decade. Pensions are a farming business, not a hunting one. The tractor may turn but it does so slowly and future risks rarely are the ones we deal decisively with today.
And finally, we need to understand what kills us today and tomorrow. Once your have figured it out, you can start to spend your time thinking about how best to mitigate that outcome. In other words, look both ways before you cross Wall Street and avoid rush hour.
What are some of the risks occupying our mind? The greatest bubble today is not one of markets or strategies, but of central bank omniscience. The start of 2016 is a reminder that central banks are human also. Forward guidance only goes so far, and if investors begin to question it, no amount of money will change that tide. Europe, for example, runs the risk of its own taper tantrum later this year if Mario Draghi, the president of the ECB, does not throw more money at the problem.
Technology and the Fourth Industrial Revolution may be the saviours as viewed by the World Economic Forum in Davos, but they are contrary to political winds today. Jobs are precarious, wages are stagnant and people feel aggrieved. Inequality is the dominant socio-political narrative. In that world, minimum wages rise. Tax laws are tightened. Labour protectionism is enshrined. None of that is positive for corporate margins. Weak demand and rising costs – the maths is simple.
Those same pressures could encourage wage inflation, even as deflationary pressures build alongside thanks to the growing quantum of debt in the system. That is a scissors pattern that could rapidly recut the investment landscape. And we have not even mentioned the worrying impact of autarky as countries refocus on domestic priorities.
But all these also create opportunities for those prepared and with the capacity to be patient. Commodities, for example, are beaten down. Oil will go down further as Iran comes back online. High yield spreads will expand further as debt burdens are exacerbated by the rising dollar and producers struggle to produce above their cost of production. But with every leg down, the attraction increases. There is a commodity cycle and we are in the trough of that cycle. The volatility is driven by oversupply for now, not demand deflation. For those happy to study the assets, but at the lows and hold patiently till the cull is complete, there are returns to be made.
The trick with all of these is not to do the exercise as a one-off but to keep revisiting, rethinking, reassessing. As scenarios are hypothesised, understand what they do to the portfolio. Track them. See if the probability in increasing or decreasing. Study the downside. Formulate mitigants and actions. That way, you run a chance of staying ahead of the curve, of preparing yourself when it is cheap to manage risk, and of benefiting as returns evolve. The greatest tool investors have is their brain. The most precious tool is time. They must use both.
Bob Swarup is principal at Camdor Global Advisors