“One of the greatest pieces of economic wisdom is to know what you do not know.” — John Kenneth Galbraith
We are well versed in simple arithmetic and basic economic laws, as our clients would expect us to be. These principles allow us to know some things about the future. For example, we know that the Greece state is unable to produce enough revenue to pay back all their debts. We also know that the next 10 years’ return for long-term bonds is probably going to be muted compared to historical averages. Similarly, we know that Social Security will eventually go bankrupt unless there are structural changes. All of these are “facts” are based on simple arithmetic and tried economic principles, and certainly our clients expect us to do the analytical work necessary to know these things. However, there are some outcomes that we cannot know, and we need to make sure that at the very least, we know that we don’t know.
What I am referring to, specifically, are the constant barrage of unknowable future events that make headlines on a daily basis. Things like elections, threats of war, bank bailouts, weather changes, and terrorist attacks are just a few examples.
Of course, as these headlines hit we have opinions just like everyone else. We have a horse in the race too, but it’s important to note that we aren’t betting clients’ money on that horse. To do so would be irresponsible, because the bottom line is that no one knows how these outcomes will turn out. Where political leaders are involved, I highly doubt even they know what they are going to do in the future. Knowing what we don’t know is a key part of being a disciplined investor, and keeping the risk profile of a client’s portfolio within the range we designed it for.
That brings me to the current economic climate, including our recent election and the looming “Fiscal Cliff.” As in other cases, we do have an opinion as to how this stand off will eventually resolve itself. However, we dare not change our strategy based on that speculation, simply because the costs to being wrong are too high. In the end, when we know what the actual policy will be, we can develop a strategy that will take advantage of the long-term implications.
Examples and Additional Notes (ie for further reading):
In 1991 the dominating headline was the first Gulf War. Would we–or won’t we–go to war in Iraq was practically all you heard in the media. A temptation for investors was to react to such headlines to anticipate the precipitous drop that would surely follow. In the end, we did go to war, and incidentally, the market was up about 30% that year.
Eight years later the Y2K scare hit the headlines, threatening to bring the newly formed “Information Age” to it’s knees. In this case, the feared event did not come to pass, but the market was down by the end of the year 2000 anyway, largely due to entirely different issues.
Our point is not that scary headlines will or will not come to pass, but rather that it is impossible to know these things in advance, and second, it is impossible to predict the exact outcome the event itself will have on the economy and the markets. The second point is often overlooked and yet just as important as the first. As the old adage goes, “everything looks clearest thru the rear view mirror.”
In the short-term, the market does a pretty good job of handicapping headline events such as these. It can usually price in the probabilities of various short-term future events well enough to make a seasoned Vegas pro proud. As Warren Buffett once put it, in the short term the market is simply a “voting machine.” Everyone “votes” their opinion by buying or selling.
There is an important distinction, though, between short-term uncertainty, which is largely priced into the market, and clear, long-term outcomes, which are often mispriced by the market. By keeping a long-term view, we are able to take advantage of opportunities that can lead to out-performance over the long term. In addition to the aforementioned basic arithmetic skills, it simply takes discipline and patience.
An example of this happened in the 4th quarter of 2008, when the big question before the investment community was if the Federal Reserve was going to act to restore liquidity to the system. Credit markets were seizing rapidly, and the headlines were occupied with falling asset prices and rising layoffs. In hindsight, we believe that the falling prices at least somewhat rationally reflected the uncertainty of that period. However, once we realized that the Fed was going to intervene, at that point we knew the ultimate end-game was not going to be a Great Depression-style recovery. The market was more than a year behind us, and therefore we were able to purchase assets at huge discounts. All of those bets paid off handsomely in the next few years.