2024 appears to have several events and circumstances with the potential to create worry. In the United States, the November Presidential election, as well as control of Congress, has already captured our attention. On the economic front, inflation remains a concern: Is it really headed down from here? And what will the Fed do with interest rates? Will they get it right and create the wished for soft landing so that unemployment remains low, economic growth high, and inflation tamed? What about the wars and conflicts in Ukraine and Gaza? Will the violence ever subside, or will it escalate? Will Artificial Intelligence stocks continue to rise, or will AI become such a danger that measures are taken to slow its growth and application? One thing is for sure, the outcomes associated with this short list are uncertain. And these are only the issues we know about.
Four years ago this Spring, the COVID-19 pandemic emerged in the global consciousness. Beyond the virus itself, watching the world basically shut down for months certainly surprised people. Prior to COVID, some of the biggest surprises might have included the 2016 election of Donald Trump, 2007 – 2009 Great Financial Crisis and mortgage meltdown, and before that, 9/11 and planes being flown into the World Trade Center. These are just a few of the very big surprises of the last quarter century that were largely unforeseen.
Why do potential events and circumstances, known and unknown, create anxious and worrisome thoughts? One reason is that the issues seem consequential. But the underlying driver of our emotions is that the outcomes are very uncertain.
But not all surprises are negative. How about the surprisingly quick recovery of the stock market in 2020 and 2021, the surprisingly rapid development of a vaccine for COVID-19, the unanticipated boom in AI that has produced surprising productivity gains? Did Iowa basketball fans forecast Caitlin Clark making 3-point shots from basketball court logos all over the country, in front of sell-out crowds? The shots and the crowds until this year were an extreme rarity in women’s college basketball.
The world is and always has been a surprising and uncertain place. As Nobel Laureate and everyone’s favorite behavioral economist & psychologist Daniel Kahneman said,
“That’s the correct lesson to learn from surprises: that the world is surprising.”
Foster Group espouses five foundational strategies or practices for better investment outcomes:
- Construct Plan Driven Portfolios
- Embrace Uncertainty
- Harness Markets
- Advance With Science
- Avoid Predictable Mistakes
Likely the most difficult to consistently apply of the five is the second, which says simply “Embrace Uncertainty”. However, sometimes the most difficult things to do are also incredibly important. Embracing uncertainty is one of those. Read on for four positive reasons to embrace uncertainty and two big dangers of not embracing it.
Embracing uncertainty helps us to have realistic expectations.
"The first rule of a happy life is low expectations. If you have unrealistic expectations, you're going to be miserable your whole life. You want to have reasonable expectations and take life's results, good and bad, as they happen with a certain degree of stoicism." Charlie Munger
If we expect the world, especially financial markets, to be predictable, having no stressful volatility, only going up and never falling (perhaps falling a lot!), we will be very unhappy, likely miserable as Charlie Munger predicts. History is a good teacher here. As we’ve said, the world is constantly experiencing surprises, unpredictable events and uncertain outcomes. If our expectation is for something else, we will be miserable. I often say that we don’t know what our expectations are until they aren’t met. If we expect certainty, we’ll be disappointed with reality. If we embrace uncertainty as part of the nature of the world we live in, we have a chance at happiness and contentment, at least more often.
Embracing uncertainty encourages diversification.
"Diversification is…an acceptance that the future is inherently unknowable and can take many different directions. If done well, it provides protection against both uncertainty and hubris.”
Joe Wiggins, Diversification Is Not a Free Lunch
Diversification is the investment concept for, “Don’t put all your eggs in one basket,” or, “Don’t pin all your hopes on one thing.” It’s a common-sense idea of risk management backed up by all kinds of academic research. When we embrace uncertainty, we acknowledge that the future will likely be different from the past and that the past did not have to work out just the way it did. If we agree with that common-sense observation, then we acknowledge that any asset or investment may experience an unexpected catastrophe, no matter how remote the potential may seem at this moment. Morgan Housel notes that on September 10, 2008 Lehman Brothers went from a tier one capital rating, which was higher at the time than both Goldman Sachs and Bank of America, to bankruptcy in 72 hours.1
Embracing uncertainty may be a source of higher expected returns.
Question: Agree or disagree. All stocks have the same expected return.
What does it mean if we disagree and acknowledge that not all stocks or companies are created equal or have the same economic outlook? Think about it this way:
- The current price of a stock reflects the market’s expectation of future return, as well as the likelihood of getting that return.
- The more uncertain the future stock price, all else being equal, the lower the price investors are willing to pay for it today.
- The lower today’s stock price relative to a future expected value, the higher the expected rate of return.
- The expected return is what an investor demands as compensation for bearing the risk, for embracing the uncertainty, of the stock price going up enough. No one buys the stock unless the potential reward for bearing the risk is high enough.
- As uncertainty increases, the expected returns demanded are generally higher, and this is reflected in lower relative stock prices. Sometimes investors get more than they expected, sometimes less, sometimes nothing.
If the expected return of the market (all stocks on average) is 10% and stock A is trading at $90.25 / share, the implied expectation is that the stock may go to $100 in the next year. The expected return for bearing the risk of stock A is about 10%. If stock B is trading at $75, for that stock to rise to $100 would require a gain of 33%. The market is made up of investors who believe Stock B is less likely to get to $100, so they are only willing to pay $75 for the stock. They demand a higher expected return, because the probability of getting $100 from the sale of Stock B in a year is less than getting $100 for Stock A over the same period. For Stock B, the expected return is higher, but the probability of getting that return is lower.
This doesn’t mean that investors should buy the riskiest stocks in pursuit of the highest expected return, but it does imply that risk (uncertainty) is very related to return.
Embracing uncertainty motivates preparedness.
When we embrace uncertainty, we recognize that relying on predictions to prepare us for a surprising world is not a high-probability way of succeeding. There are things that can go wrong that we can imagine. And more worrisome, there are things that can go wrong that are currently beyond our imagination. As Morgan Housel writes1,
“Risk is dangerous when you think it requires a specific forecast before you start preparing for it.”
Morgan Housel, Same As Ever
With this thought in mind, Nassim Taleb, author of “Fooled by Randomness” and “The Black Swan,” encourages people to, “Invest in preparedness not prediction.” For investors embracing uncertainty, this likely means holding some assets that are as disaster proof as possible, like Treasury Bills and money markets. Outside the investment portfolio, it may mean having an emergency kit in the house or car with water, blankets, first aid kit, fresh batteries, non-perishable food, and some cash. You’re preparing, in general, for an event that you are not able to specifically predict.
In California, buildings are constructed to survive possible but uncertain earthquakes. In Florida, it’s not earthquake preparedness but hurricane preparedness that matters most.
On the other side of the coin, it’s a good idea to be prepared for positive circumstances. The stock market generally rises, though not always. In preparation for future periods of positive returns, an investor needs to have a plan to stay invested. Since you must be present to win in stock market investing, if you embrace uncertainty, you’ll be more likely to hold your portfolio through the down periods in order to benefit from better markets when they arrive.
Let’s look at two dangers of not embracing uncertainty.
If we don’t embrace uncertainty, we risk becoming needlessly fragile.
“Risk is what is left over after you have thought of everything.”
Carl Richards
“Risk means more things can happen than will happen.”
Elroy Dimson
If we embrace uncertainty, we give ourselves the opportunity to be prepared for a wide range of surprising outcomes, both good and bad. If we don’t embrace uncertainty and risk all or most of our assets on a narrow prediction, it follows that we are relatively more fragile if unexpectedly poor outcomes occur. In the late 1990’s, stocks associated with dotcom companies were going up like rockets. Then starting in April of 2000, the excitement faded and the dotcom heavy NASDAQ Composite Index fell by over 50% of its value in less than one year.2 While I am not predicting that this will happen, it is possible. The sentiment driving stocks associated with artificial intelligence (AI) higher may, at some point, reverse and result in significant losses for those who have made big bets on only those stocks. The same could be said for oversized investments in Bitcoin.
If we don’t embrace uncertainty, we risk vulnerability to unrealistic and dishonest investment pitches.
Humans prefer certainty to uncertainty. When we don’t embrace uncertainty as the normal state of the world but think of it as something that can be eliminated, we will be tempted to look for someone who promises certainty. From Bernie Madoff and other Ponzi schemers, to those who naively overpromise results which they cannot guarantee, sadly the history of investment fraud abounds. When we don’t embrace uncertainty and something goes wrong with our current portfolio or plans, we'll be tempted to abandon them, not because it wasn't a good portfolio or plan but because we got impatient or unlucky. Nothing can be more detrimental to long term investment success than a short-term mindset and a limited understanding of probability. If we don’t embrace uncertainty, we’ll start looking for someone or something that guarantees a better outcome when a result disappoints us. And unfortunately, in our vulnerable state of mind, we won’t have to look far to find someone to tell us what we want to hear so that stock market losses can be virtually eliminated.
The reality is that the US stock market has historically experienced a negative calendar year return in about one of every four years.3
In the forty-five years since 1979, there have been nine (one in five) years where the stock market was down 20% or more during a specific calendar year. However, there were only three calendar years when it actually ended the year down over 20%.4 This is like saying that, based on historical data, there is an 80% chance of not having a bear market this year. This is also the same as saying that there is a 20% chance of having one! Embracing uncertainty means that we expect bear markets as a regular cost of achieving long-term stock market returns, even though we don’t know exactly when they will occur or how long they will last. Understanding risk and probability is critical to, as Munger said, “…take life's results, good and bad, as they happen with a certain degree of stoicism." With this kind of outlook and understanding of history, we are able to embrace uncertainty and less likely to fall for those folks who are promising the impossible, a risk-free, predictable and certain future.
In review, embracing uncertainty is not easy but if we can do it, there are at least four positive results for our investment experience. Embracing uncertainty:
- Helps us manage expectations
- Encourages diversification
- Is a source of higher expected returns
- Motivates preparedness
And if we don’t embrace uncertainty, two big potential consequences are:
- We risk becoming needlessly fragile.
- We risk being vulnerable to false promises and a short term mindset.
Educated optimism is an antidote for anxious uncertainty, and it can be of great help in enabling investors to embrace the uncertainty that is with us all the time. Questions about embracing uncertainty? Reach out, we’d love to have a conversation with you.
1Morgan Housel, Same As Ever
2NASDAQ Composite market data provided by Dimensional Fund Advisors
3CRSP 1-10 US market data provided by Dimensional Funds Advisors
4Russell 3000 market data provided by Dimensional Fund Advisors