The Current Situation
The world is currently gripped by macro uncertainty with Trump’s trade wars, a long in the tooth bull market that continues to run, debates over high debt levels in a potentially increasing interest rate environment and expected inflationary pressures. All this culminating in an expected equity markets correction in the coming years and a recession in developed markets. This era of uncertainty lead me to think about the effects of basing decisions off statistical probability versus consequential implications. Big words that mean “how best do we navigate the unknown”.
What do I mean by this?
Before I explain myself, let us reflect on the some of the large-scale events that have occurred in the last couple of years. Some of these may illustrate the point I intend to make. Firstly, and depending on your stance, the notorious or acclaimed Brexit vote of 2016. I remember it with clarity due to acquaintances having to rush into the offices at 3:00 AM. They were desperately trying to close out their open positions. Stock tumbled as news went out that the referendum was passed as a “leave”.
Brexit went against what most people thought was going to be a “stay” majority.
Another example was the Trump election. On the election night, as the results started to indicate an increasing likelihood of a Trump victory against initial polls, markets went haywire. Near midnight, futures for the benchmark S&P 500 and Dow Jones Industrial Average indexes fell by over 4%. The US dollar tumbled during election night. Although it quickly recovered as Trump’s fiscal policy was expected to raise the dollar higher owing to the potential economic growth and inflation that could result from a big stimulus push.
Trump won the election because of the voting system that US uses. Hillary won the popular vote, which means if every persons vote was equal – Hilary would be president.
As I sat in New York with a South African rand-based salary and watched the dollar strengthen over a period I could not help but consider those that invest in the “unexpected”. Surely there is away to profit off the unexpected?
Now the reason I have put this in inverted comma’s is because there is a difference between unexpected and improbable. Improbable or implausible are unexpected but that does not mean unexpected is improbable or implausible. This can be explained simply as – a square meets the definition of rectangle [a quadrilateral (4 sided shape) with 2 sets of parallel lines and 4 right angles. A rectangle however does not meet the definition of a square [a quadrilateral (4 sided shape) that has 2 sets of parallel lines, 4 right angles, and 4 equal length sides]. A square is a rectangle but a rectangle is not a square.
Both Brexit and Trump were unexpected events but not totally implausible. Both were not the favourites but were expected to get a large number of votes. Expectation was that they would not get the majority. The financial markets priced in the favourites. These being a “stay” vote and Clinton presidency.
Why would you bet when the odds are not in your favour?
Betting on the favourites will win out in the end right? Not always – there are situations were you better off taking the underdogs.
Here is an example. If you could invest into one of the following shares which will be affected by a very predictable upcoming macro-event, which would you choose?
Share A: A macro event will occur with a 90% probability and if it occurs the share price will increase [i.e there is a 10% chance of a decrease]
Share B: A macro event will occur with a 10% probability and if it occurs the share price will increase [i.e there is a 90% chance of a decrease]
It seems obvious you would take Share A, that has a 90% possibility of increasing. Or would you need to know more information in order to make your decision? The problem is you may have negated the consequential implications.
As the market prices in the likely outcome, the loss and gain are not proportionally equal. For instance, because the market has priced in the 90%, Share A increases by a nominal 1% (the market knew it was coming and anticipated it so it had already been bought up). In the case of Share B the market priced in a decrease and it goes down 1% (only large risk takers still held the share and it had already been sold down).
What happens if the event that the market predicts, doesn’t end up occuring?
Share A would have many risk adverse investors holding the share, hearing the news they knee-jerk and sell out resulting in a tumultuous decline of 15%. Meanwhile, Share B has the opposite and all the investors flood to it on the back of the good news and it is up 15%?
I suppose we must ask the question: “is it worth being a contrarian when the market will always approximate towards the more likely?”. Well only if the odds are precisely accurate. With news more accessible than ever, there is a plethora of fake or ill-sourced information that distorts reality – this website a clear example.
There is a case to take on board lower downside risk for large upside. It all depends on your risk appetite and the related reward. The risk-reward changes for a variety of reasons although perhaps it is worth taking a risk with some of your portfolios on the unexpected? Trump Election and Brexit suggest you should.
Although decisions should be made with probability in mind, a successful investor will look past mere probability and factor in consequences.
To end off with a more clear example, which would you be choosing…?
A – 99% chance to win R 100 (1 hundred rand)
B – 0.01% chance to win R 1,000,000 (1 million rand)