Staking your money in a risky financial world
However, regardless of your current situation or perception of the world, only you can change it for the better.
It is important to remember that the outlook for the global economy and financial markets is as it always is: Uncertain, highly uncertain. Of course, the challenges and the opportunities might be slightly different from this time last year, but we can expect a range of possible outcomes.
Human nature craves certainty, hence investors seeking answers cling to short-term market predictions.
However, we should beware of the fallibility of such predictions when constructing a financial plan.
At the beginning of each year ,there is a ritual across the big Wall St investment firms which requires them to release their predictions for the year ahead. For example, they will provide a forecast for the closing value of the S&P 500 Index at the end of 2016.
The results from 2015 show that almost all firms were overly bullish. The year before, they were too conservative. This is not to denigrate the research they provide, I am just not convinced about the value of such predictions.
I have just finished a very interesting book, Superforecasting: The Art & Science of Prediction, by Philip Tetlock and Dan Gardner, which I would encourage anyone who wants to learn more about forecasting to read.
As Tetlock and Gardner point out in the opening of the book, “We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a new product, or retiring, we decide based on how we expect the future will unfold. These expectations are forecasts.”
The authors share interesting insights on the workings of the brain that drives our decision making, how to appropriately evaluate decisions made, as well as a way of thinking that can improve your own judgement on how things will unfold in the future. Reading the book will also help you to see through the charlatans of this world, of which there are many in the financial services industry.
As I look ahead for the remainder of the year, I can see the same challenges that everyone else can: A deeper slowdown in the global economy led by China and the emerging markets; the fallout from the collapse in commodity prices; the repercussions across bond markets when liquidity is tested; the Fed’s efforts to normalise monetary policy; the impact of a stronger dollar; and how the central banks’ experiment will end. Quantifying the impact and the timeline when these risks might affect major equity and bond indices is a difficult task.
There is no simple answer to the question, “how will the markets perform for the rest of 2016?”
There is a range of probable outcomes, opportunities and risks, but certainty is a rare commodity as you move out the risk spectrum from short term cash deposits. The vague language used to convey how events might unfold can frustrate clients. Even when we use numbers to articulate the probability of an investment return, there can be confusion.
This challenge is not limited to predicting the performance of financial markets. Tetlock and Gardner cite examples where the US government misinterpreted the expected outcome of military action conveyed by the wording of intelligence estimates.
In 1961, president John F Kennedy was told by his joint chiefs of staff that the CIA-led plan to topple the Castro government by landing a small army of Cuban ex-pats at the Bay of Pigs had a “fair chance” of succeeding. As we now know, it was a massive failure.
However, it later turned out that the author of those words said he had in his mind odds of 3/1 against success. As the authors point out, perhaps President Kennedy’s thought process on whether to give the go-ahead may have been different if the chiefs had said: “We feel it’s 3/1 the invasion will fail”.
Perturbed by this disconnect, Sherman Kent, one of the leading figures in US National Intelligence at the time, proposed adding percentage probability intervals to the wording, to better convey the likelihood of the event happening. It was never adopted, for a variety of reasons.
“Some expressed an aesthetic revulsion. Language has its own poetry, they felt, and it’s tacky to talk explicitly about numerical odds. It makes you sound like a bookie,” prompting the response from an unimpressed Mr Kent: “I’d rather be a bookie than a goddam poet.”
However, one objection I thought relevant to our own use of probability in investment markets was: “Expressing a probability estimate with a number may imply to the reader that it is an objective fact, not the subjective judgement it is.”
The message is one that resonates with my own beliefs on forecasting: “Numbers, just like words, only express estimates — opinions — and nothing more.”
Still, rather than becoming overly focused on markets, I think the first and most important step in uncertain times should be to define what you are looking to achieve.
Over the years working with private clients and corporate trustees, I have noticed a tendency to put the emphasis on forecast returns ahead of actually determining the objectives. Even when objectives are set, they can often be too vague to add any real value. They must be realistic.
Whether it is setting investment strategy for defined benefit schemes, defined contribution schemes or individual clients, having a decision-making framework in place can add some certainty in an uncertain world.
For individuals in a private pension scheme, this is only one part of their overall wealth, and so it is always advisable to make investment decisions for these accumulated funds in the context of an overall financial plan.
In setting your personal financial plan, do not make the mistake that most people do, and ignore what may be your greatest asset of all, human capital.
Where financial capital is your accumulated monetary and physical assets minus liabilities, human capital is effectively your future earnings power. The type of job you have will dictate the safety of that human capital or the upside and it can influence the risk you take with your financial capital. Think public service versus venture capital.
Either way, for many people, increasing the value of your human capital — through education, personal development and travel — will be far more lucrative long-term than fretting about where the S&P 500 will close at on the last day of the year.
