Last week, I had the pleasure of catching up with Andrew Pease, an investment professional I have known for 30 years. The last time I met with Andrew was in London when he was head of Russell Investments Europe. He has now returned to Australia as Chief Investment Officer for Russell Australasia. He doesn’t miss the cold, dreary days.
We had a wide-ranging discussion. Like me, he could not explain the meteoric rise of bitcoin, gold, and equity markets simultaneously and was quick to point out, from a valuation perspective, that none of it made sense. He also made the point to me that every market crash looks obvious in hindsight, and no one can consistently predict when that will occur or what the trigger will be. We are all aware that a major crash can be devastating, wiping out years of an investor’s savings.
What Andrew and I have in common is an interest in history and a belief in probability-based investing. The philosophy is straightforward: focus on what is most likely to happen based on many years of market history. Or to coin a phrase, I often use ‘trees don’t grow to the sky’.
No one can predict markets – to do so is folly. However, based on probability, you can insulate clients’ portfolios from significant losses. Investment models typically chase returns by trying to predict which asset classes will perform best, in what mix, and in the current and estimated future economic climate. In other words, they use mean-variance optimisation, which aims to maximise return for a given level of risk.
This is well and good. However, probability-based investing is a separate overlay that accounts for the likelihood of different outcomes. So it adds an element of caution. It means we can improve the chances of mitigating client losses.
We are all cognitively wired to feel the sting of a loss more strongly than the pleasure of a similar gain. Given my time as an Adviser and my experience through many market cycles, I know what it’s like to explain to a client that years of performance have been wiped out by one catastrophic event. It’s not a conversation you really want to have. Further, these events trigger emotional responses in clients, such as panic selling or performance chasing.
If you lose 50%, you need a 100% gain to break even again, before accounting for the opportunity cost of the returns that you could have made. History has consistently shown that the real wealth destroyer in downturns isn’t the crash itself – it’s what investors do in response. Selling at the bottom, piling into defensive assets after they’ve already rallied, or delaying re-entry are all common and costly mistakes.
At Future Gen, we practice probability-based investing. Everyone on the team has studied statistics, and we all understand that investing is a bell curve. While out performance can occur and has occurred over the last five years, there will always be a reversion-to-the-mean event.