Reasons for Investors to expect the unexpected

Investing is inherently risky and will always contain uncertainties. However, by taking risk, investors have a greater potential for higher returns, although this also presents the potential for losses. Nobody can predict the future or factor in every possibility to their plans, but careful portfolio construction can help to limit losses. As we continue to live through uncertain times, with raging wars, potentially changing political environment and the effects of an unprecedented pandemic still being felt, it’s little surprise that investors are feeling nervous. Here we look to outline some key sources of uncertainty and talk through the way The Private Office can help clients to mitigate the effects. 

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1. What are the sources of uncertainty for investors? 

Market Volatility

Volatility is an inherent component of financial markets and reflects the ability to rise and fall suddenly in a very short space of time, due to diversity of sentiment and analysis among investors. Some times sentiment swings wildly one way or another, driving volatility. Equally, external events like elections, natural disaster and geopolitical conflicts can cause markets to react in a swift and violent manner. Recent examples include the Russia-Ukraine war and the Covid pandemic. Investors who, in a state of panic, sold when markets dropped missed the subsequent recovery in asset values. A long-term perspective, therefore, is key to avoid unnecessary losses and to ride out the short-term volatility. 

Technological Disruption  

Changes to technology is a constant through human existence, although it happens in fits and starts. As such, investors can be caught off guard by rapid changes in technology and the impacts on old industries. Not many foresaw how much Amazon would impact retail or how Netflix would impact media distribution. Looking for technological trends can help investors avoid being left behind.

Regulatory Changes

Changes to laws, regulations and government policies can have large impacts on investors and their portfolios. It is, of course, very difficult to predict changes in regulation, but you may choose investments that have a lower regulatory risk level – for example investments in firms that are aiming to reduce environmental impact reduces the risk that they fall foul of future environmental regulation and consequently suffer fines.

Geopolitical Shocks 

Markets often undergo significant turbulence during times of acute uncertainty, and geopolitical shocks often raise the spectre of great uncertainty due to the wide degree of possible outcomes, ranging from swiftly negotiated peace all the way through to world war. As such, conflicts increase the price of risk to market participants, thus causing asset prices to decline in the immediate term. This is to say nothing of the impact on supply chains of ongoing wars – the Russia-Ukraine conflict being a good example, with the outbreak of the war causing a spike in energy and grain prices. Geographical diversification is a key to help minimising this risk.

Business Scandals & Contagions

Business scandals, often involving fraudulent accounting and business practices, understandably have serious impacts on the asset values of the involved companies, however investors often tar entire industries with the same brush, causing sector wide selloffs. Enron’s 2001 collapse is a good example, as it resulted in a period of heightened volatility across the energy sector. Avoiding concentrated positions can minimise this risk.

Economic Shocks

Economic data that is wildly out of the consensus expectations often causes sharp moves in financial markets, as investors incorporate this new data into their outlook on the world and thus their asset allocation frameworks. A recent example of this is the flare up in inflation in 2022 and the subsequent interest rate hikes by central banks. Rising costs of financing causes investors to reappraise the fundamentals of many of the companies they invested in and to change investment strategies. Keeping an open mind and assessing a wide variety of outcomes can help partially mitigate this risk.

Black Swan Events

Black Swan events get their name from the Victorian belief that a black swan did not exist, only for explorers to find them living in Australia. As such, events that are incredibly unlikely, but impactful, are called Black Swan events. The outbreak of the Covid pandemic is an example of a Black Swan event. By definition, these events catch investors off guard. Only by creating robust risk-modes and stress testing portfolios can you then help limit the impact of these events.  

Overconfidence & Biases 

Humans are prone to biases when making decisions: loss aversion, overconfidence and confirmation bias can hurt investors and lead to bad decisions. Remaining disciplined and working with an adviser to understand your own biases can reduce the risk of making poor investment decisions.

Complacency & Herding  

Another very common mistake among investors, particularly the inexperienced, is to follow the crowd.  “How can this be a bad investment if everyone else is buying?”. As everyone rushes out, it can result in spectacular losses in a short period of time – the late 90s tech bubble crash is a good example. This behaviour can be common in social situations but can be financially damaging as a result of losses when the tide turns.  Once again, diversification is a way to help avoid these outcomes.

2. How to deal with uncertainty 

Diversification

Diversifying your portfolio across asset classes, geography and sectors is key. Concentrated positions increase investment risk from all those mentioned above, market volatility, regulatory changes, technological disruption and business scandals. By allocating between multiple countries, you help avoid the risks that geopolitical events in one country bring your whole portfolio down. Creating portfolios with equities, fixed income and alternatives lowers correlated risks due to economic shocks and black swan events.  Correlated risks are risks that are correlated to each other, for example inflation and interest rate risk are correlated (when inflation rises, often interest rates do too) so if your equity holdings are susceptible to pressures on margins from inflation, as well as suffering from a high debt load that is impacted by interest rate rises, you are exposed to two correlated risks.

Time in the market (not timing the market) is key

A long-term investment mindset stops investors from panic selling at the bottom and herding into the same assets as everyone else. Through history, equity markets have consistently risen over the decades even if they have fallen over short periods. Timing the markets can be a fool’s game with only 18% of hedge fund managers getting it correct the majority of the time.

How we can help

At The Private Office, our investment philosophy is to create long-term, diversified portfolios that benefit from the structural trends shaping society, while mitigating risk through a diversified allocation across geographies and asset classes. We aim to reduce risk by avoiding keeping all eggs in one basket whether those 'eggs' are countries (geography) or types of investment (bonds, stocks, alternatives). Our advisers compliment this with advice that keeps clients-long-term interests in mind with their own tailored investment strategy, to help avoid rash decisions that can harm your financial outcomes. 

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

Investment returns are not guaranteed, and you may get back less than you originally invested.

Past performance is not a guide to future returns.