The Russian army’s intimidating presence on the border with Ukraine is the latest macro event that has investors concerned about equity markets. It is also the latest macro event that most investors would do well to ignore*. We worry about specific, prominent issues because we want to protect against the losses that may occur if our worst fears are realised. The irony is the most sure-fire way for investors to make consistent and substantial losses is by lurching from one high profile risk to the next, making consistently poor decisions along the way.
We have all seen the charts extolling the virtues of taking a long-term approach to equity investing. They show how markets have produced strong returns in-spite of wars, recessions, and pandemics. They are a great illustration of the benefits of a long-term approach, but they don’t tell us everything.
What they fail to show is all those critical issues that worried investors but never came to pass. We are always confronting the next great risk to markets; the key to successful investing is finding ways of drowning out this noise.
There are two key reasons why this is incredibly hard to do:
First is how the media and industry serve to stoke rather than quell damaging behavioural impulses by obsessing over the latest macro risk. It’s far more interesting to speculate over the potentially dramatic implications of a given situation, than to repeat some boring lessons about sensible investor behaviour.
Second is that because some events have mattered in the past and some will matter in the future, we feel compelled to act on everything – just in case the current issue really does have an impact. Imagine if disaster strikes after we told everyone to disregard the risk.
Even though we can be certain that there are some events that will cause dramatic (short-term) losses for risky assets; discounting them is absolutely the best course of action for most long-term investors. This is for a host of reasons:
We cannot predict future events: Pre-emptively acting to deal with prominent risks that pose a threat to our portfolios requires us to make accurate forecasts about the future. Something that humans are notoriously terrible at.
We don’t know how markets will respond: We don’t only need to forecast a particular event; we also need to understand how markets will react to it. What is in the price? How will investors in aggregate react? Even if we get lucky on point one, there is no guarantee we will accurately anticipate the financial market consequences. Take the coronavirus pandemic – if at the start of 2020 we had been able to see into the future and look at the economic data for the year ahead, we would have almost certainly made a host of terrible investment decisions. In investing, even foresight might not be enough to save us from ourselves.
It is worth pausing to reflect on these first two reasons. Forecasting events and their impact on markets is an unfathomably complex problem to solve. We are incredibly unlikely to succeed in it.
2016 is useful example of this problem. For both the US election and Brexit (two macro risk obsessions at the time) investors were wrong footed by both elements – the forecast of the votes (even though they were binary) and the market reaction to them. Years and months were spent pontificating over positioning for those events, and many very intelligent people got everything wrong.
When questions are posed such as: “What are you doing in your portfolio about Russia / Ukraine?” It is useful to unpack what is really being asked here, which is: “With limited information and a huge degree of uncertainty and complexity, have you made an accurate assessment of the likely outcome of the tense political / military stand-off between two countries, and then judged the market’s reaction?”
The answer should be no.
If the answer is yes, then we are displaying a huge degree of overconfidence.
We are poor at assessing high profile risks: We tend to judge risks not by how likely they are to come to pass, but how salient they are. This a real problem for macro events because the attention they receive makes them inescapable, so we greatly overweight their importance in our thinking and decision making. This is why the media and industry focus on them is so problematic – it makes us believe that risks are both more severe and more likely to come to fruition.
We need to be consistently right: Even if we strike lucky and are correct in adjusting our portfolio for a particular event, that’s not enough – we need to keep being right. Making a bold and correct investment decision about a single event is one thing, but what about the next one that comes along? We need to make a judgement on that too, we can’t undo all our prior good work. Over the long-run being right about any individual prominent macro event is probably more dangerous than being wrong, because it will embolden us to do it again.
Most events will not matter to our long-term returns: Daniel Kahneman’s comment that “nothing in life is as important as you think it is, when you are thinking about it” could be used in relation to short-term events and our long-term outcomes. In the moment that we are experiencing them macro events can feel overwhelming and all-encompassing, but on a long-term view they are likely to fade into insignificance.
It is not that macro events are never significant for markets. There will be incidents in the future that will lead to savage losses in equities; we just won’t be able to predict what will cause them or when they will happen. Trying to anticipate when they will occur, rather than accepting them as an expected feature of long-term investing, will inevitably lead to worse outcomes.
If we find ourselves consistently worried about the next major risk that threatens markets, there are four steps we should take:
1) Reset our expectations: Investing in risky assets means that we will experience periods of severe drawdown. These are not something we can avoid, they are an inevitability. They are the reason why the returns of higher risk assets should be superior over time. We cannot have the long-term rewards without bearing the short-term costs. We need to have realistic expectations from the start.
2) Check we are holding the right investments: The caveat to ignoring the risks of major macro events is that we are sensibly invested in a manner that is consistent with our long-term objectives. If we have 100% of our portfolio in Russian equities, it might make sense to be a little anxious about recent developments. The more vulnerable our investments are to a single event, the more likely it is we have made some imprudent decisions.
3) Engage less with financial markets and news: There is no better way to insulate ourselves from short-term market noise and become a better long-term investor than to disengage from financial markets. Stop checking our portfolio so frequently and switch off the financial news.
4) Educate ourselves about behaviour, not macro and markets: What really matters to investors is not the latest macro event or recent markets moves, but the quality of our behaviour and decision making. We need to shift our focus. The asset management industry can do a lot to help here because at present it does little but promote noise and unnecessary action, inflaming our worst behavioural tendencies.
Provided we are appropriately diversified, the real investment risk stemming from major macro events is not the issue itself but our behavioural response to it – the injudicious decisions we are likely to make because of the fears we hold.
We need to find a way of worrying less about markets and more about ourselves.
* As I hope is obvious, this observation is purely from an investment decision making perspective. Macro events will often have profound human consequences, which we should absolutely not disregard.