Coping with Uncertainty
“Oil falls on middle-east uncertainty.”
When financial markets are volatile, you often hear that “uncertainty” is the cause. This suggests that uncertainty comes and goes, but because financial markets are forward looking, and because the future is unpredictable, investors must cope with uncertainty all the time.
That can be hard, especially in volatile periods when the value of your investments is fluctuating from day to day. How can investors learn to cope with pervasive uncertainty?
Pricing-in uncertainty
It is important to remember that the market is a very effective information processing machine. This means that millions of market participants around the world are continually assessing information and its expected effect on future cash flows and that prices change as participants act on this. It is therefore reasonable for you to work on the assumption that today’s market level has priced in current uncertainty.
Benefits of hindsight
Investors can also take comfort from remembering that a globally-diversified portfolio has recovered from many periods of uncertainty and crisis.
For example, in 2008 the stock market dropped in value by almost half. It was a period of uncertainty so acute that the viability of global money markets as we know them came into question. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,” “Markets in Disarray as Lending Locks Up,” and “For Stocks, Worst Single-Day Drop in Two Decades” were elevated from the business page to the front page.
Every political or economic crisis poses different challenges and affects the market in different ways, but the experience of past events can help investors maintain perspective.
The temptation to react to events can be strong but reacting is not always the best thing to do. In the heat of the moment in the financial crisis, some people decided to sell out of stocks. Those that stayed the course and stuck to their approach have long since recovered from the crisis and benefited from the subsequent rebound in markets.
There have been many periods of substantial volatility in the past. Exhibit 1 (page 3) helps illustrate this point. The exhibit shows the simulated performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.
Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three-, five- and ten-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial adviser can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.
Conclusion
As we know, predicting future events correctly, or how the market will react to future events, is difficult. The good news is that being a successful investor does not rely on making accurate predictions. It is important to understand that market volatility is a part of investing and to enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. Accurately predicting the future is not a prerequisite to be a successful investor.
A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.
Dimensional On: Markets Rewarding Discipline
Jake DeKinder, Head of Advisor Communication, explains how capital markets have rewarded investors who are able to tune out short-term noise and stay disciplined over the long term.
Click here to view the video.
Appendix
Balanced Strategy 60/40: The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the adviser’s decision making if the adviser were actually managing client money. The balanced strategies are not recommendations for an actual allocation.
Dimensional All Country World Core 2 Index: Compiled by Dimensional from Bloomberg securities data. The index targets all the securities in the eligible markets with an emphasis on companies with smaller capitalisation, lower relative price, and higher profitability. Profitability is measured as operating income before depreciation and amortisation minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional Fund Advisors and did not exist prior to April 2008. The calculation methodology was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index.
The Dimensional and Fama/French Indices reflected above are not “financial indices” for the purpose of the EU Markets in Financial Instruments Directive (MiFID). Rather, they represent academic concepts that may be relevant or informative about portfolio construction and are not available for direct investment or for use as a benchmark. Their performance does not reflect the expenses associated with the management of an actual portfolio. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. See the appendix for descriptions of the Dimensional and Fama/French indexes.
The Dimensional Indices have been retrospectively calculated by an affiliate of Dimensional Fund Advisors Ltd. and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index’s index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.
Source: Dimensional Fund Advisors Ltd.
The views and opinions expressed in this article are those of the author and not necessarily those of Dimensional Fund Advisors Ltd. (DFAL). DFAL accepts no liability over the content or arising from use of this material. The information in this material is provided for background information only. It does not constitute investment advice, recommendation or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful. Diversification neither assures a profit nor guarantees against loss in a declining market.