Partner Talk®
November 2015
No One Knows the Future
Robert Capanna
[email protected]
While it sounds somewhat oracular, this is about as true a statement as you will ever find: no one
knows the future with certainty. PMA clients and friends will recognize this as a seminal statement
of (non) belief at PMA – our entire process of investing is predicated on our sure knowledge that we
do not, cannot and should not expect to be able to predict what will happen in the markets on any
given day.
This is not a source of despair, however, nor is it some kind of informational failure. This is the fate
of all of us who live in a world where the future is not preordained.
However, while we do not know the future with certainty, we do know the range of likelihoods that
exist in the future and we can assign probabilities to various potential outcomes. In fact, making
predictions about the probability of certain outcomes is a very rational way to conduct your life and
a necessary part of being a successful investor.
Let’s take the famous case of a fair coin toss. We all know the odds of heads or tails on any
particular toss is even. But we also know other things about the coin toss: given a copper penny,
the result will never be “red”, or “black” or 6 or 23. In other words, we know the range of potential
outcomes – heads or tails – and we can assign a probability to one or the other – 50% for each. If
we toss a coin and expect to get either heads or tails, we are operating in a sensible and coherent
way. If we are hoping for “red” or 23, we are going to be disappointed.
Of course investing is more complicated than tossing a coin, and the range of outcomes is much
greater than binary, but given a particular investment we can reasonably predict the range of
investment outcomes that we could expect in a given period.
1735 Market Street • Philadelphia, PA 19103-7598 • phone 215-994-1062 • fax 215-994-1064
www.prudentmanagement.com
For instance, we might invest in the stock of a single company. Assuming that we had perfect
knowledge of that company’s operations, we might be able to make very accurate predictions about
its future growth and earnings. On the other hand, our perfect knowledge can never include the
unknown, and when that company’s CEO leaves, or the plant blows up, or its business model is
disrupted by some unforeseen innovation in the market, all bets are off, as they say.
Let’s say instead that we invested in the stock of 10 companies that are all established, mature
businesses in a proven market sector, like banking for instance. We still cannot know the unknown
and unforeseen things that may disrupt any one of their businesses, but now at least a catastrophe
at one company is not going to take down our entire portfolio. But since the companies are all in the
same industry, industry level disruptions (like a global credit crisis, for instance) could significantly
damage our overall holdings.
So maybe we should consider spreading our portfolio over the wider market and include the stocks
of businesses in other sectors, like transportation, retail, energy, etc. And maybe we should
consider an allocation to the stocks of smaller, younger companies that have good potential for
growth, as well as our established, mature businesses. By diversifying our portfolio, we are
spreading the risk so that a negative outcome for one company or market sector will not destroy our
entire investment.
We are also significantly increasing our sample size and instead of needing perfect information at
the company level, we can begin to rely on broader trends for industry sectors and for the equity
market as a whole. We still do not know the certain outcome of the equity market return, but we
have a broad enough sample that we can be more specific about our range of expectations. By
studying the historic returns of the market, we can deduce two key numbers that will help us
establish a reasonable range of potential outcomes: the average return over time and the degree to
which returns fluctuate around the average period to period, which is the volatility of the returns and
represents the degree of risk that the return will be other than the average return.
So now that we have a diversified, all equity portfolio, we can say a few things about our
expectations. Since the equity market (represented by the S&P 500) has had an average return of
about 10% a year historically and the range of returns vary year to year by about 15% to 20%, it
would be reasonable to expect our portfolio to have an annual return somewhere between -10%
and +30% about two thirds of the time. One third of the time, the annual return could be less than or
greater than that range.
This is a wide range of returns, but it does make some outcomes seem extremely unlikely. For
instance, we would not expect that it would be likely for the return to be -100% or +100% in any one
year. We would also expect that over time, the outcome would be more positive than negative,
since the market has had an average positive return historically.
But given the volatility of equity returns, it would be a little like expecting a coin toss to return “red”
to expect an all-equity portfolio to be a smooth and pleasant ride year to year. Especially if we are
relying on our portfolio to produce a somewhat predictable income stream, we will need to tamp
down the volatility by introducing an asset class with less variability in its returns: bonds.
Of course bonds are subject to the same or similar risks that we see with equities. There is the risk
that the issuer of the bond will go bust and not repay the obligation, akin to the company level risk
we saw above for stocks. There is also industry risk in corporate bonds just as there is in stock
investments. And there is duration risk in bonds as well: certainly a promised return for two years is
more likely to be achieved than a promised return for 30 years. But as we did with our equity
portfolio, we can mitigate these risks by constructing a bond portfolio that is broadly representative
of the bond market and perhaps avoids issues with lower credit ratings and longer durations.
Now, like we were able to do with equities, we can rely on the broader historic average returns and
variation in returns for the entire bond market to make some predications about likely outcomes for
our bond portfolio. We find three things: the average return is lower (about 5.5% for the Barclays
Aggregate US index over the last 20 years); the variability of returns is lower (about +/- 3.5% a
year); and, the best news of all, a negative correlation with equity returns: bond and stock returns
tend to move in different directions.
Now we can construct a truly diversified portfolio of stocks and bonds and we can reasonably
expect some things with a high degree of certainty about its future performance: the greater the
portion of stocks we have, the higher the expected return should be over time and the greater the
returns will vary from year to year; the higher the portion of bonds we have, the lower the expected
return will be but the return will vary less from year to year. Not only will the balanced portfolio be
inherently less risky, but the more even return stream will be more appropriate for those with
current spending needs.
Of course there can always be unforeseen catastrophes no matter how many precautions we take
and how diversified our investments are, but if you are going to be concerned about the future, you
have to assume that there is going to be one.
And at PMA, while we do not know what the future will bring with any certainty, we are confident
that the unique combination of laws and freedoms that underpin our economic and financial system
make it better than an even bet that the future will be there for some time to come.