It’s human nature that we tend to favour certainty in the stock market. But times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it.
Whether it is in our personal lives, throughout our careers, or our foray into the stock market, we spend a considerable time attempting to reduce uncertainty. In many cases, we prefer the certainty of an outcome that may be slightly less desirable than the prospect of a better outcome that is subject to greater uncertainty.
This means that when we are confronted with uncertainty, we tend to automatically go into preservation mode and think the worst is before us. For example, in the stock market, the first sign of a downturn might prompt us to raise our expectations about the possibility of a crash that takes years from which to recover.
We tend to address this by actively seeking out ways to minimise our uncertainty. However, there is good reason to believe that might not necessarily be the best approach. After all, this can involve significant opportunity cost, whether it be selling stocks at an inopportune moment, or failing to take advantage of favourable investment opportunities.
Our inability to know the future
The last two years have been unprecedented on a number of fronts - from the pandemic to the shutdown of the global economy and travel, as well as monetary and fiscal policy - but that hasn’t stopped experts putting forward a wide range of opinions and forecasts about what might unfold in the stock market.
However, as with any type of forecast, the accuracy of stock market predictions only becomes clear with the benefit of hindsight. That’s because every topic relevant to the future, including smaller outcomes about companies, is determined by thousands of interdependent factors that require a great deal of assumptions and certainty. Yet, assumptions and certainty often don’t ‘marry’, especially the bigger the topic.
We tend to draw on history to help us forecast, and it may seem logical, but history is only a guide for inferences, opinions and tendencies. One of the most fitting quotes that describes this comes from former GE executive Ian Wilson, who said: ”no amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future”.
As such, drawing on history to forecast is neither a rule-based approach nor scientific. It can be subject to inconsistencies and random events that give rise to imprecise outcomes. The truth is, a pattern-driven framework doesn’t work in unprecedented scenarios because there are too many limitations and unknowns. In many respects, there are more questions than answers. Famous US statistician and author Nate Silver put it best when he said: “We need to stop, and admit it: we have a prediction problem. We love to predict things—and we aren’t very good at it”.
Now, this is not to say everything about the future is an unknown outcome, because some events or trends are based on common knowledge. But this information does little in serving us any sort of competitive advantage, and in the stock market, this information is unlikely to yield outperformance. On the other hand, unpredictable outcomes or black swan-like events do drive above-average results, but the extreme difficulty here is that these predictions rarely eventuate.
The key to forecasts that drive outperformance is to acknowledge, respect and embrace uncertainty. One of the most fundamental ways to do this is to ensure that we demonstrate intellectual humility, which is being open-minded to the fact that we could be wrong in our beliefs, or that there may be limitations to the basis of our beliefs. We discard internal bias and acknowledge uncertainty - we don’t know everything. Pausing on these thoughts ensures we are confident without being arrogant.
All of our due diligence must be thorough in the first instance, revalidated, and then implemented cautiously. Even though returns might not necessarily outpace those who go ‘all-in’ with their aggressive forecasts, we shield ourselves from far greater downside exposure when we are wrong.
Separating uncertainty from risk
One of the common misconceptions in the market is that uncertainty and risk are the same thing. While they may be interconnected, given uncertain events tend to be risky in nature, there is an important distinction that often goes without observation. First, risk is a probability of an undesirable outcome, which in the market would typically be a permanent loss of capital.
However, a decision mired in uncertainty may be beneficial to achieve a desirable outcome, provided you have done your due diligence in order to mitigate your risk. This is why people invest in the stock market instead of putting money in the bank, as most have a tolerance for the uncertainty that may be required in order to generate what are typically higher returns compared with cash.
For a specific example, consider the younger generation, which have a long investment horizon. The certainty of a fixed-rate of return associated with investing in cash is unlikely to help a young investor achieve a desirable outcome, which is generally to build up their long-term retirement wealth by achieving returns that at least exceed inflation. On the other hand, someone nearing retirement would be well served by more certainty and stability in their investment environment.
Understanding this difference is something that is at the heart of being able to identify investment opportunities, even during a volatile period as we are witnessing right now. This is because uncertainty often presents itself as a risk to investors, prompting losses across the market to ‘snowball’. When this momentum leads to ‘mispriced’ outcomes, uncertainty provides investment opportunities for those with conviction to buy. This is why we should embrace uncertainty.
Embracing uncertainty in a rational manner
When we consider human behaviour, we tend to place a premium on the notion of certainty. This certainty, however, doesn’t necessarily need to be real either. In many cases, it may just be the perception of certainty that reassures us.
This may explain why some tech stocks trade at lofty valuations. While they often don’t have certain future cash flows, their projected growth guides to a perceived certainty they will continue to grow at a high rate. Deep down, however, we know this is uncertain. And at the first confirmation of uncertainty, these stocks are sold off sharply. Perceptions matter as much as the underlying story.
As long as we have a system with which we can prepare ourselves mentally in dealing with uncertainty, and methodically evaluate investment opportunities, then uncertainty will afford us more opportunities to become successful investors. Keep in mind, if businesses like banks and insurers can establish highly profitable operations on the very premise of accepting uncertainty, we also have the same opportunity.
Blindly embracing uncertainty isn’t the mantra here. Rather, it is about rationally embracing a level of uncertainty that is commensurate with the risk and quality of the opportunity. Value investing is often seen as one approach that seeks to take advantage of mispricing that occurs during uncertain environments. It focuses on the fundamentals of a business that have been momentarily disturbed by the ‘noise’ of uncertainty. These moments present rare chances to add high-quality stocks to your portfolio, and if you are afraid of uncertainty, opportunities may pass before your very own eyes.
The risk of irreversible loss of capital for high-quality companies with strong fundamentals is low. By nature, these companies tend to be resilient and often bounce back stronger than before. With the rarity with which these stocks see short-term sell-offs, some of the most-successful investors are those that position themselves to take advantage of these opportunities during uncertain times. Of course, the key here is to separate high-quality stocks from low-quality companies, as well as positioning our portfolios for a multitude of risks.
For all the doubts and concerns that emerge when uncertainty rears its head, most of this is self-inflicted because we assume the worst and overstate the risks of a worst-case scenario. We use history, trends and assumptions to make forecasts since we can’t rely on rules or science. However, there is an asymmetric upside to uncertainty, because it can help us train our focus, recalibrate our investment decisions, and also identify new investment opportunities.
The ability to exercise intellectual humility and grapple with self-doubt is something that is invaluable. By knowing more about what we don’t know, we are better informed and may increase the likelihood our forecasts are right, or at least reduce the number of poor decisions we make.
Investing in high-quality companies is an inherent way to mitigate downside risk during uncertain periods, and often presents a low-risk, high-reward situation. At the end of the day, uncertainty is a fact of life, and in the stock market, if you are not prepared to acknowledge, respect and embrace uncertainty, you may be left behind.
Have a great week,
George Wong - Certified Financial Planner