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The Certainty of Uncertainty

David Andrew
David Andrew
Posted 09.02.2022 in Industry Updates

Every conscious person wakes each day with an expectation of how their day, their week, their year will pan out. Here’s how it unfolds from there…

  • When we get LESS than what we expect, we are unhappy.
  • When we get EXACTLY what we expect, we are ambivalent.
  • When we get MORE than we expect, are happy.

During the pandemic, a problem we all have is that the goalposts are constantly shifting, and so are our expectations. Whether it is opening up, staying closed, or the supply of RAT tests, it is tiring keeping up with the constantly evolving commentary on how we should be thinking.

This uncertainty extends to our expectations of what will happen in the economy and financial markets.

Very early in the pandemic, there were expectations in some quarters of the worst recession since the 1930s, but far from being correct, these predictions were upended when the share market provided double-digit returns in 2020, and markets continued strongly in 2021.

Right now, the media is predicting a gloomy outlook as talk of the supply chain, rising inflation and rising interest rates dominate the narrative. When it comes to rising interest rates it is interesting to look at the assumption that when interest rates are rising, the share market performs poorly. Is it a certainty? Can we set an expectation around it?

Fed Funds Rate Chart

The data above from the US suggests that the opposite may be true and that share markets can continue to perform strongly until rising rates finally bite and cause the economy to slow.

There’s no doubt that if interest rates rise enough, some homeowners may need to reign in their spending to make their household finances balance, but a return to more normal interest rates (from these historic lows), will be healthy for the Australian economy in the long term.

Then there’s our expectation of the share market.

Markets have had an extraordinary run for the past few years with most investors quietly pleased with their portfolio performance. But since 2 January the S&P500 index has fallen 6.17%. (The Australian S&P/ASX200 index has fallen 6.31% for the same period). Will they fall further?

I have come to understand that our most successful investors are those who accept uncertainty as a necessary part of being an investor. If we never accept the possibility of a market downturn, we are always going to be unsatisfied when they occur. If we accept market downturns as part of the normal operation of a portfolio, we can rationalise that we need to take the good with the bad.

The scatter graph below confirms this, showing the annual returns of the US S&P 500 index since 1928. What we see is a random dispersion of returns, year by year, for many years. The critical piece of information in this scatter plot is the average return an investor received over the period. Answer = 10% per annum. The best annual return in the graph above is 52.6% while the worst year was minus 43.8%, and there was everything else in between.

S&P 500 Annual Returns 1928-2021 Graph

The average rate on cash over the same period was 3.3% per annum, giving an equity market premium of 6.6% per annum; a handsome reward for any disciplined investor.

I like to think of my investment portfolio in a similar way to nurturing our little orchard. To harvest successfully there are many things we need to do to maximise the chances of success. From soil balance, nutrition, keeping pests at bay just for starters. But no matter what I do, some harvests work out better than others.

In 2022 I expect there will be an increasing chorus of experts telling us what they think is going to happen next, and given the uncertainties we all face, the likelihood of them being right is pretty random. The best expectation we can have will be that markets will do the unexpected. They may continue to perform very well, or they may be volatile. Our best advice is that expecting volatility should be our default position. That way if markets are volatile our expectations will have been met. Maintaining portfolio discipline remains the biggest predictor of investment success.

 

The author acknowledges the work of Ben Carlson – a Wealth of Common Sense in the preparation of this article.

David Andrew
David Andrew
David Andrew
Founder and CEO of Capital Partners, and author of Wealth with Purpose, David firmly believes that sound, objective financial advice can transform peoples’ lives and wellbeing. Find out more about how our evidence-based approach to wealth planning, investment management, legacy planning and insurance distinguishes our award-winning team, our results and our clients’ lives.