Doubt is not a pleasant condition, but certainty is an absurd one. — Voltaire
“The market hates uncertainty” is a common enough saying, but does it make any sense? Actually, people hate uncertainty. Uncertainty has many different aspects: some that can be measured and some that cannot. The ever-mutating nature of uncertainty in the enormous world around us is a constant condition of our human existence. Individual investors may feel more or less uncertain, but the effect on their confidence is a personal phenomenon, related to their risk-taking propensities and individual situations that should condition any sensible investing approach.
In contrast with individual investor sentiment, uncertainty is an inherent and integral part of a well-functioning market — as stocks, bonds and commodities trade daily worldwide, perpetually seeking equilibrium between faceless (and increasingly bloodless) public and private buyers and sellers. Any security possessing an expected return above the prevailing “risk-free rate” (think Treasury bills for U. S. investors) trades off the certainty of a stable government guaranteed $1 value for a potentially (and presumably greater) increased return that may be only realized months or even many years in the distant future.
Consider uncertainty through the simple lens of stock vs. bond investing. Stocks have higher expected returns than bonds largely because the future state of the world is more uncertain for equity investors than for bond investors. Most bonds have fixed coupon payments and a maturity date at which principal is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure. In the event a firm goes bust, bondholders get paid before stockholders. So, should investors avoid stocks in favor of bonds due to this increased uncertainty? Quite the contrary: many investors allocate substantial amounts of their portfolios to stocks because inherent in that very uncertainty is a higher expected return. Many investors’ decisions to own stock portfolios are highly influenced by interest rates much too low to finance their established lifestyles. In the end, any investor must make either an informed or uninformed risk-return tradeoff, accepting increased uncertainty to hopefully capture at least some higher return as the reward.
MANAGING EMOTIONS
While the statement “the market hates uncertainty” is not logical, we have a lesson here. Thinking more deeply about the expression offers insight into the mindset of the typical investor. Personifying the financial market — aggregated trading activities of many widely dispersed participants all competing for profit — ascribes the very real nervousness and fear many investors feel when market volatility unexpectedly increases (a fear aided and abetted by an aggressive attention-seeking media). It recognizes that markets move up and down in what may seem, viewing it day-by-day, like a random walk. All too often, investors serve their money rather than have their money serve them, and struggle to separate their emotions from their stocks. Consequently, regardless of whether markets are advancing toward new highs or suddenly declining, market change becomes a source of anxiety and stress for millions of investors paying too close attention to the media but without a wise advisor to guide them in making informed decisions.
Unnerving periods of serious market declines may not feel like a good time to remain invested, much less to buy stock to maintain an allocation strategy. In such times, the media fills with tearful stories of fearful investors selling their stock portfolios, and clutching closely their cash in a death grip. Yet only in hindsight — sometimes requiring the perspective of decades — do we feel as if we know whether this or that time was good to be invested, or if it was particularly rewarding for market segments. Unfortunately, while the past may be prologue, the future is never certain. No investment comes with a performance guarantee.
So what considerations should an investor keep in mind in order to sensibly expect a positive and potentially highly rewarding outcome?
STAYING IN YOUR SEAT
In a recent interview, Executive Chairman of Dimensional Fund Advisors David Booth was asked about how long an investor needed to plan in order to confidently enjoy the benefits of investing in equities.
“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or even have a positive return?’ And my answer is it’s at least one year longer than you’re [likely] willing to give. There is no magic number. Risk is always there.”
The secret to enjoying peace of mind during volatile market periods when uncertainty rages all about is owning a fully diversified portfolio structured around scientific dimensions of return. That portfolio should align both with an investor’s willingness and with his or her risk capacity. Also, whether we feel times are good or bad, no one should expect to earn a higher return without taking higher risk. In the famous words of a Nobel laureate, “There is no free lunch.” Informed investors are selective in owning only those risks strongly associated with expected returns identified from decades of research and data, and then holding them for one year longer than they originally planned.
While falling prices in a market decline never feels good, with a truly informed investment strategy, recognizing that uncertainty is inherent in investing, and planning a sensible portfolio policy with an investment horizon stated in terms of years and not days, will help media-challenged investors avoid overreacting. Education in what matters and discipline with the guidance of the right advisor, dramatically increases the chances of a great financial experience — especially so when results capture those elusive market returns in those succeeding years after all that market uncertainty when most other investors you know did not.
Letter From the Chairman
Dimensional founder David Booth reflects on the importance of sticking with the right long-term investment philosophy. His letter historically illustrates the positive long-term outcomes of structured dimensional multifactor strategies compared to the vast majority of traditional approaches that futilely attempt to forecast stocks and time markets. Letter from the Chairman.
For more interviews with David Booth, please go here (go all the way to the bottom, Institutional Investor Money Masters video)