- Assumptions used to build investment thesis often do not take into account a full spectrum of risk possibilities.
- Most often, analysts estimates of economic outcomes is wrong.
- When estimates are very wrong, they tend to result in a surprised populace unprepared to cope with the fallout.
- Investors should consider a risk-based approach to investing that more strongly incorporates counter points to current assumptions.
- Having some risk insurance in your portfolio needn’t significantly reduce overall returns, but may help save your finances should you ever need to use them.
When building an investment portfolio, we often make assumptions about certain variables in order to facilitate strategies to invest money. In order to provide as much flexibility as possible in making decisions, we often use a sensitivity model to scope out various scenarios.
From those scenarios, we have a basis for making decisions considering various potential outcomes. Based upon the expected outcomes, analysts often then model a portfolio with the desired returns.
Assumptions by their nature are not based on real knowledge of the future, but instead decisions we make based upon past history of performance. Quite often we trend asset classes, also referred to as technical analysis. However this is really nothing more than using previous data to forecast future returns.
That being said, many times our assumptions are often wrong. They are most visibly wrong when large market moves occur that contradicted most people’s assumptions. That is often because the fundamentals supporting our technical analysis are constantly changing due to various contributing factors that may lay outside the scope of our analysis.
One famous example was in 2008 during the mortgage crisis, in which lending dried up and the S&P fell 38.5%. Per the New York Times:
Consider the calamity of 2008. If you had money in stocks that year, you would probably remember. The S.&P. 500 fell 38.5 percent in the course of those 12 months. It would have been very useful to have received advance warning that stocks were about to plummet, but the Wall Street consensus did not ring out an alarm. On the contrary, the forecast for 2008 was unusually bullish, calling for a rise of 11.1 percent. Wall Street missed the mark by 49 percentage points that year.
Now this is not some random error, but another in a long line of missed analyst estimates. The fact is that analysts are wrong more than they are right. From the same NY Times article:
How bad is the industry’s track record in making predictions? I had assumed that the annual forecasts were essentially worthless — no better than flipping a coin. But Salil Mehta, an independent statistician who has blogged about the topic, tells me I’ve been too kind. The forecasters, as a group, are much worse than that.
“It’s not easy to be as bad as they are,” he said in an interview. “They are much worse than random chance alone would predict.” (Mr. Mehta was formerly the director of research and analytics for the United States Treasury’s Troubled Asset Relief Program and for the federal Pension Benefit Guaranty Corporation.)
So how bad are the predictions?
After examining forecasts by major investment houses going back to 1998, Mr. Mehta found that 8 percent of individual analyst predictions called for a small market decline in subsequent years. But those predictions of decline were worse than random: In the years when the market did fall, 9 percent of forecasts — never enough to counter the bullish consensus — predicted that it would happen, essentially the same as in a year in which the market rose.
If anything, what this tells us is that making future predictions based on past periods doesn’t yield consistently valuable future results. The lesson is that we should be more open to building substantive counter points within the assumptions we use in our portfolio models to allow for real market variances.
The World Changes, So Our Risks Should Too
Recently I have written about many of the economic and political changes that seem to be more rapidly occurring across the world. In Europe’s Alternative To Swift Another Nail In The Dollar’s Coffin, I discussed how former allies in commerce are moving to alternative payment systems and how this would weaken the US dollar’s status as reserve currency. This substantial risk should be included in our investment assumptions.
For example, I have discussed how the dollar’s melt-up (defined as increased value when fundamentals are actually weakening) is negatively affecting emerging market performance, which is hurting US companies that are counting on substantial growth from overseas business investments.
Not only that, but it makes servicing existing domestic debt, whether by paying down or refinancing, more expensive as interest rates continue to rise. This is another substantial risk that should be included in our investment assumptions.
But how many of us are actively doing this for our investment models? Many people seem to be ‘copy-pasting’ previous assumptions into their 2019 predictions without making substantive changes when risk factors change.
Real World Experience Is Valuable
One thing that I find of particular importance in assessing my portfolio is to seek out real world experiences in different situations. I find this immensely more valuable than using purely academic models, or just relying on backward-focused technical data points.
Those that have followed my work know that I prefer to model business risks than to build out what I consider fantasy-land predictions on future financial performance. The main reason being, of course, is that those predictions almost always come out false. It is within that lens that I seek out those who have industry expertise or real life experience in the risk scenarios I am using to manage my money.
Because I had recently written about Argentina’s currency problems, I reached out to Fernando Aguirre, a survivor of Argentina’s last currency crisis and economic collapse, for insight which you will find in the following interview.
I believe that the problems Argentina is facing are merely one of the dominoes that will affect the US dollar simply because all of our different debt-based fiat currencies are intertwined with one another through the banking system and also through international trade agreements. You simply cannot isolate currency risk within a single regime anymore than you can stop one bank failure from precipitating another. We learned this during Lehman.
The interview with Fernando is very interesting for several reasons. I asked several complex economic questions and received very real-world responses based upon his experience in living in an higher risk scenario. What Fernando was able to tell me is what happens when our assumptions were badly wrong. This is exactly what I was looking for in assessing potential risks that most analysts are not likely focusing on in their 2019 models.
For instance, notice how Argentina used to be one of the most successful Latin American economies up until the day it wasn’t. In fact the Argentine Peso was pegged 1:1 to the US dollar. That is because the fundamentals of the economy were changing over time, and the risks resulting from those changes were not accurately assessed by economic analysts. As a result, the people simply were not prepared, and economic chaos ensued. The currency has never recovered, and the IMF is back to bailing out the country again.
I think it particularly interesting to note that Fernando’s mother and father worked in the financial industry and did not have much advanced warning of the currency crash. Their were rumors of potential problems, but it is not the case that the financial industry workers were any better off in the long run.
Having lived in Argentina, Ireland, and Spain, Fernando had a lot of unique insight into different economic and political systems around the world. In particular, I found his comment that American’s don’t understand Europe politically and economically as very interesting. What could be effects of this on our portfolios?
Consider for a moment that US companies operating in Europe have more substantive risk than we have considered. If Europe is receiving substantial financial investment from China and forming new trade agreements with partners in the Middle East, for example, how does this affect trade with the US? In a world of limited resources, it would seem to put pressure on US corporate expansion plans overseas. Has anyone built that risk into their assumptions for future US corporate growth?
Another key takeaway from the interview was how Fernando viewed possible Latin American cooperation in the Mercosur as being potentially less likely than the European Trade Union sticking together. Are these risks built into your assumptions for companies that do a lot of trade with Latin American countries?
At the same time that economies are erupting in South America, migrants are attempting to cross the southern US borders in droves. If all of these immigrants don’t find ready work when they get here, then they would likely be added to US welfare roles in some form or another. This likely raises unfunded liabilities of those programs.
This of course puts more burden on our national debt, and as an extension, the US dollar, which is already more at risk than anytime in the recent past. This is an add-on effect of the suffering South American economies that likely no major economic analyst predicted ahead of time.
In retrospect, it might make more sense for the American administration to assist the South American countries in forming a stronger trade alliance to support one another’s economies, which may have the effect of increasing production and employment and reducing potential refugee flow to the US. But recent policy direction from the administration don’t indicate work is being done by the US on an economic solution.
Reflections on Personal Finance
In particular, notice how the politicians did not tell the people explicitly about the currency revaluation during the crisis. When the banks reopened, they just revalued the currency at 3 pesos to 1 dollar instead of 1:1. This meant that those with debt, in particular the business owners who are the productive class of the economy, struggled to pay loans with currency worth 1/3 of its previous value. This situation didn’t help the economy to recover.
In the event the US experiences a debt and currency crisis, I asked Fernando what was valued in times of real financial crisis. His responses were interesting in that hard assets under personal control were better. For example, having cash, gold and silver was a good idea to meet expenses in the event of a job loss. The banks simply told people to go away and did not give them their money.
For income investments, Fernando stressed income generating assets such as rental real estate under your control. In this situation, REITs would not continue to generate as much income as retail and industrial businesses failed under the spending freeze gripping the country.
Further, stocks crashed during this period about the same rate that the currency was revalued. Even if the brokers could sell shares, any proceeds were locked away in the insolvent financial system and the banks would not release funds to account holders. Lastly, public bond holders were wiped out as Argentina defaulted on its debt.
So it seems that passive investments such as ETFs, stocks, and bonds suffered the worst losses while real assets offered better protection. The rise of passive investing in the US has seemed to dumb down markets and may be exacerbating the mispricings of the market.
It may be time to consider some substantive risk counter points in your assumptions. And to protect against those risks, it may be worth your time to consider hard assets as a percentage of your portfolio, viewed as risk insurance. Should these risks not materialize in the next year, then you haven’t really lost much other than may be a few points of growth off the top of your portfolio return. However, the downside of not having this valuable insurance could have much more tragic consequences.
Lastly, I would like to thank Fernando for taking the time to discuss his experience in Argentina, and his knowledge of the European political situation. For more detailed discussion on his Argentinian experience, please visit our After Hours session where we talk more on how to protect yourself in the event of an economic crisis.