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Making Sense of Chaos

Investors Chronicle 2014, winner of CFA article of the year

 

Investment is about trying to build certainties into an uncertain world. Expected average rates of return in various markets, how much we should save, how long we are likely to live. Implicit in all this is the trust that, if we defer consumption – either through our savings, or via state and private pensions – that it will be there for us half a century later, increased in value – and of course that we will survive to enjoy it.

Looking at a broader canvas of human experience illustrates this. The idea that an individual can, at 20 years old, plan for a healthy and wealthy retirement 50 years later is one that would be laughable in most of human history.

Only in the past 60 years and only then in the most developed countries and among the better off did it ever seem a reality. As Nassim Nicholas Taleb might observe, there are black swans everywhere – yet we cling to our certainties, because for the previous few decades they seem to have worked.

We’ve had the best part of 70 years, since World War II, to turn these assumptions into iron truths, and just half a dozen years, since the banking crisis, to start to doubt some. But our questioning isn’t yet deep or fundamental enough and is still tainted by the island of security that the post-war years represented in our greater history. “People think in linear terms, but this is a non-linear world,” said Joseph Lampel, a professor at Cass Business School in London. “Extrapolation [of past trends] is a seductive temptation, for politicians and the public. It is often wrong.”

The end of certainty

There are many reasons to believe that chaos is creeping back up on us once again, and which would indeed suggest that the years of post-war stability and growth were more a blip than the norm. Not least of these is that the great revolutions that underpinned 20th century economic progress – technology, globalisation and healthcare – appear to have reached their zenith, to a point where the incremental benefit they can deliver is proving ever more marginal.

Meanwhile, the massive central banking experiment that has taken place over the past six years has made it harder to predict with any certainty which way markets will turn – especially now that signs of economic improvement in the US has prompted a ‘tapering’ of quantitative easing. Such a day was always going to come, but the turbulence of the last fortnight suggests that the markets could react very badly indeed as words become deeds over the next few years.

In such an environment, in which the investment truisms that have guided our thinking through the past half century no longer hold true, we need to rethink our investment approach, and develop strategies that can cope with such uncertainties. Yet to do this, we must first understand what the certainties that can no longer be relied upon are. Here are six of them.

1) Faith in the durability of markets

Our faith in the survivability of security markets over a human lifetime is touching, but misplaced. Spain’s debt experience in the eurozone hasn’t yet caused it to default, and it may not. But that would be historically unusual. Spain defaulted on its bonds in 1809, 1820, 1831, 1834, 1851, 1867, 1872, 1882 and from 1936-1939. As a London Business School 2002 paper demonstrated (Elroy, Dimson & Marsh: Triumph of the Optimists), survivorship bias, our temptation to ignore the effect on historic investment performance of markets or securities that failed, has substantially overstated the performance that those investing in the past could actually have achieved.

That isn’t just the bankruptcy of individual companies and the voiding of their securities, but the failure of investments held through intermediaries, such as Lehman’s derivative contracts, and of the markets themselves. Dozens of security markets, from Cuba to China, from Russia to Hungary, have failed entirely in the past 100 years. Add to those the near-disasters in Latin America in the 1980s, and more recently in Greece and Cyprus. It is no longer just revolutions that kill markets, but financial convolutions and financial interconnectedness. A single trader has the power of an army.

We think of these as exceptions to a ‘normal’ stability, but there are good reasons for doubting it.

The rise and propagation of novel financial instruments, globalised capital markets and ultra-rapid trading have given individual traders, corporations and markets more ways to kill themselves. The risk junkies – from Parmalat to RBS, from Icelandic banks to Greek governments – have broken into a well-stocked global financial pharmacy in pursuit of thrills, and have rolled up their sleeves. The horsemeat scandal illustrated the lack of control big supermarkets had over product provenance when the supply chain became extended. But this is exactly what happened in the banking crisis too, when the length of the banking food chain between ultimate lender and ultimate borrower became so long that banks with collateralised debt obligations (CDOs) didn’t know what they owned or who they had lent to. So while human life expectancy has increased radically in the past 20 years, there are reasons to fear that the life expectancy of financial systems has shortened. If so, the chance of a single individual experiencing a systemic financial meltdown in her lifetime is multiplied.

This is just the first of many dying truths. Here are another five, plus four more that are already dead and buried.

2) Economic growth is inevitable

The belief that economic growth is the natural order of things is deeply ingrained. Few of us have known anything else. Post-war experience has been that every dozen or so years, the West gets a recession that causes a year or so of economic contraction – an economic sniffle – and then bounces back to trend growth.

The last crisis has been more like ’flu than a sniffle, but many still assume growth will resume. Why should it? First, we have unprecedented environmental challenges: climate change, overpopulation and risks to sustainable food and water supply. While growth from the value of human ingenuity (think Apple or solar panels) tread lightly on the earth, exploitation of tar sands and fracking are the environmental equivalent of tearing the sofa apart looking for loose change.

Second, western economies are being eclipsed. The long history of China and India illustrate a cycle of expansion, over-stretch, decline and fall which has been seen again and again over history. The fact that we call them emerging, rather than re-emerging, economies shows how readily we forget history.

While the substitution of trade for military competition in the past 70 years might be argued to ameliorate that brutal cycle, the relative economic decline that Britain is currently experiencing may well be a more enduring experience. Decline may be relative not absolute, but we should still expect longer periods without growth in the new cycle, and shorter periods with it. Upside: growth is over-rated anyway, ask those in buoyant Beijing who battle smog every day.

3) We can expect to live longer than our parents

Longevity is the bane of actuaries and pension trustees, but there is nothing inevitable about ever-longer life-spans. Russia, for example, has never managed to get life expectancy above 70. Poorly educated white women In the US lived five years less, and equivalent men three years less, in 2008 than they did in 1990. There are similar pockets of disadvantaged groups in many countries, buried under more cheery-seeming averages.

Medical progress may be inevitable, but will occasionally be offset. Look at antibiotic resistance. “If we don’t take action, in 20 years’ time we could be back in the 19th century where infections kill us as a result of routine operations,” UK Chief Medical Officer Professor Sally Davies told the World Health Assembly in May. “In the last five years we’ve seen a step-change in the level of resistance… and in some cases a doubling of the death rate.”

4) Mankind can overcome environmental challenges

Those anxious about climate change already accept this assumption is dead, but optimists and naysayers do not. Textbooks say environment is a spanner in the works of the engines of business, investment and consumption, and a cost that sits outside the control of enterprise. Yet, we have precedents that show governments can act together. The Montreal Protocol of 1987, which brought together 116 nations to phase out chlorofluorocarbons, was, according to former UN chief Kofi Annan, “perhaps the single most successful international agreement to date”. It might also be the exception that proves the rule.

5) Globalisation will march onwards

Globalised trade has largely been a boon, causing a steady fall in the costs of household goods in the west in the past three decades, undermining the economic might of organised labour and building rising incomes in China and beyond. How far can it go? The theoretical limit is when real wages across the globe equalise, or differences at least aren’t sufficient to overcome trading and transport costs. We aren’t there yet, but other factors intervene. “We are reaching the high point of globalisation,” Mr Lampel said. Extending free trade agreements is getting ever harder, running up against the last national refuges (rice in Japan, films in France, genetically modified foodstuffs, farming subsidies).

Any military conflict, of course, smashes free trade hopes among affected countries. If globalisation steps back, the global economy loses and we all feel poorer. As Mr Lampel notes, a British parliamentary committee was once asked to look at the prospect of European war, and smugly concluded it was unlikely because of the trade interconnectedness of the continent’s economy. The year? 1913.

6) The Internet will remain a free and global network

Cultural and political influence has already eroded the experience that internet users in various parts of the world can expect. In China, Burma, North Korea and parts of the Islamic world, free expression and content choice are filtered. But given the web’s capacity to be a conduit for espionage and cyber attacks there may be those who eventually see the disadvantages of connectedness outweighing the advantages.

Expect it to be a rougher ride from now on: more policing of what you buy and from where, by the intellectual property owners; more attempts to gather your personal data for commercial and security reasons, and state attempts to assert control (read: taxes and regulation) as more commerce migrates to the net. That covers everything from sales taxes to bureaucratic liabilities imposed on websites and service providers.

The certainties that already died

7) Banks can be trusted

Old hat, of course, since the collapse of Northern Rock in 2007, the implosion of Lehman Brothers a year later and the state-sponsored rescue of banks all over Europe and North America. Last summer’s refinancing plan for the Co-operative Bank is a reminder that it isn’t over. Everyone now accepts that banks are at least as fallible as any other institution. But for the previous 140 years, from Overend & Gurney in 1866, not a single British bank collapsed. It is important to remember how safe we felt, and how poorly based that perception turned out to be. One related truth I didn’t even bother to include, because few ever accepted it: That regulators can protect us.

8) Governments pay their debts

The eurozone crisis has seen to that one. But actually, across Latin America, Africa and the Caribbean there have been hundreds of defaults since the 1800s. While we haven’t seen an absolute sovereign default since Argentina’s in 2001, we now better understand the relationship between overblown banks and underfunded states, and prudent governments and imprudent ones. We’ve long not believed what they say. Now we don’t trust them to pay their bills either.

9) Our children will be better off than we are

Those UK babyboomers who retired with good final-salary schemes have been the big winners of the past few decades. Their state pensions are – quite unsustainably – triple-locked, to match the best increase of average earnings, prices or 2.5 per cent. Their education was free, even the living expenses at college were covered by a grant. And because they were few, they got real gains from a degree. Today’s kids, educated or not, live in a tougher world – and that’s before you even consider the future of the planet. Collateral damage has been done to one related certainty…

10) Higher education is always a good investment

Education isn’t immune to supply and demand. When everyone is a graduate, there is a smaller premium for those not-so-rare skills, and one increasingly insufficient to dent the rising cost of going to university and other fees in acquiring those skills.

“Politicians love to sell linear stories, higher education participation as a cause of growth. But even people who undertake the education are not always getting the value,” Mr Lampel said.

While elite institutions will always earn a premium, that is as much about restricted intake as true value. If you really want to see the bad effects of ‘diploma disease’, Mr Lampel says, look at the surfeit of angry graduates in Egypt, Nigeria and Kenya. There’s material for a revolution, if you want one.

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