We live in uncertain times. Market volatility returned with a vengeance last year, as US-China trade tensions, the chaos surrounding Brexit and social unrest in Europe caused political turmoil to intensify. Moreover, economic fundamentals turned from a tailwind to yet another source of market uncertainty.
Cyclical indicators have nosedived in recent months and the unprecedented environment of low inflation and low interest rates persists, despite tighter global labour markets.
This creates unusual puzzles for many asset managers, some of whom think their investment approach should use a more long-term investment horizon. They argue that it is better to deliver more long-term-oriented value to investment clients, rather than being dazed and confused by short-term market and macro mysteries.
A thoroughly considered long-run perspective is always needed. The simplest guideline is that investors will earn a risk premium (in excess of a cash return) by carrying market risk on their invested capital. It is also pretty clear that diversification (spreading the risk over different asset classes and securities) improves the trade-off of an investment portfolio’s volatility and the returns that it generates in the long run. These two core arguments (risk premiums, diversification) clearly justify a long-term allocation to financial markets for investors who seek above-cash returns for their savings or for their clients’.
However, the implicit assumption that an investment portfolio’s long-term performance is enhanced by focusing less on shorter-term market drivers and more on longer-term drivers is not as easy to support with evidence as the increasingly popular narrative suggests.
First, one does not have empirical observations as evidence for such a hypothesis. Using 5- or 10-year investment horizons does not generate a lot of testable data points. Assessing the benefit of 5-year horizons in one’s investment analysis would require 500 years of history to come to a small sample size of 100 observations on which statistically relevant data could be analysed. Working with 10-year horizons only amplifies the problem. When using long-term macro or valuation measures to enhance the strategic design of a portfolio, empirical evidence is pretty hard to find.
Second, the world is not necessarily more uncertain in the long run than it is the short run. It might feel that way, because we experience stress only in the short run and tend to forget how differently we thought and felt about things that happened longer ago, something that is well documented in behavioural science. Moreover, we are often educated to think that our economies and markets behave in a stationary way – that is, that future outcomes in the economy and markets are “normally” distributed and that these variables move in stable, cyclical ways around some unobservable equilibrium to which they converge as a result of gravitational forces embedded in the traditional “laws” of economics and finance. In reality, this is observable neither in the short nor the long run. On almost any time scale, macro and market variables express non-normal behaviour with unpredictable irregularities and large outliers or fat tails.
Our economic system is much more complex and adaptive than classical theory suggests. Periods of stationary calmness have always been unexpectedly disrupted by much less normal and more volatile regimes, and at very irregular intervals. This creates many more path dependencies in the system than stationarity assumes. It makes long-term assumptions vulnerable to misperception regarding where a future “equilibrium” might gravitate our economic reality towards over time. Increased shorter-term adaptability to recent shocks and emerging economic regimes is therefore indispensable for delivering attractive long-term investment results.
To illustrate the fragility of basing an investment approach too much on long-term anchors, just look back 10, 20 and 30 years.
In early 2009 we were in the wake of the credit crisis and in the midst of the Great Recession. The Fed was on the verge of opening its unconventional toolbox of quantitative easing, and many pundits with a long-term perspective were either claiming that another Great Depression was ahead of us, or that excessive monetary easing would cause a debasing of the US dollar and an unprecedented spike in global inflation. Neither of these perspectives would have been very useful as guidance for a long-term-oriented investment approach in the decade that followed.
Ten years earlier, the situation was very different. Financial markets were approaching the peak of the IT bubble. Belief in the arrival of a “new economy”, one that would generate decades of high growth and low inflation, was stronger than ever before. Basing an investment approach for the 1999-2009 period on the tech religion and unprecedented growth assumptions would have been detrimental to any investment strategy over that period.
Similarly, in 1989 the world again looked very different. In most of Europe and the US the economic outlook was clouded. The positive consequences of the fall of communism and the massive acceleration of globalization that followed were far from fully appreciated yet, and the economic boom in Japan had just reached its peak (and would shortly after be followed by a massive collapse!). Many felt that the Japanese model was superior and would be duplicated in the West, either voluntarily or because Japan would force it upon Europe and the US. However, betting on Japan at that point in time would probably rank as one of the worst investment decisions ever made.
All this means that we need to be humble about what we can know about the long term. No matter how complicated the short term might look and feel, long-term thinking does not automatically solve your problems. Substantial caution should be built into long-run assumptions. Collecting risk premiums by allocating capital to markets in a diversified way is certainly a credible long-term approach that should be embedded into most investment strategies, but other long-term enhancements have to be critically challenged as possibly being more fantasy than real added value. Many of them can be possible future outcomes and can be very useful in stress-testing and as part of broader scenario analysis. But the multitude of potential future scenarios, the complication of assessing their likelihood of materializing and therefore the persistence of uncertainty, also in the long run, should never be forgotten. In the end, the only certainty is uncertainty!