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,”1 “Markets in Disarray as Lending Locks Up,”2 and “For Stocks, Worst Single-Day Drop in Two Decades”3 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 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.

Ex1

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.

Ex2

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.