November has been a rollercoaster for investors and much has already been written about the ‘unprecedented’ and ‘exceptional’ rotation that occurred following Pfizer’s announcement about the efficacy of its COVID-19 vaccine.
The primary focus of commentary has been the swing in underperforming stock markets relative to those that had previously been strong, which has brought with it differential relative performance between equity factors that have rarely, if ever, been seen before.
Only time will tell if recent market moves are sustained, although many participants will have their own views. It also remains to be seen whether strategies that use leverage predicated on the unprecedented not occurring, will be caught out by these moves. What happens next is not the focus of this blog article.
The risks that we can see coming, and those that we can’t
From a portfolio management point of view, what is so interesting about recent events is that they provide a beautiful and timely example for thinking about two types of risk: those we can see ahead of us, and those we cannot and which appear out of the blue.
The event risk that has been most prominent in investors’ minds in recent weeks were the US elections on November 3rd. This is very typical – scheduled events of significant political magnitude are always a focus of attention. They are anticipated by a bombardment of media coverage, analyst commentary and broker reports suggesting ways in which to ‘hedge’ certain market outcomes.
The temptation with such events is to try to ‘sit it out’ until we have ‘greater clarity,’ or to seek protection. As always, uncertainty is more frequently framed in terms of bad things that can happen; in this instance the risk of a contested result was frequently discussed as the most negative outcome possible for markets.
And yet we have just seen the problems with this type of thinking. First, the fact that you are probably trying to hedge the same risks, at the same time as everyone else, means that you have less chance of making money even if volatility does pick up.
Second, and more important, is the role of the events that we couldn’t put in our diaries. The US elections have been the focus only to have been superseded by news about a COVID-19 vaccine.
The lessons are clear. We should try to think as much about things that might happen at any time as we do about scheduled events. And even then, we should recognise that there are always surprises ahead of us, as things we never imagined come along. How many 2020 outlook pieces cited the risk of a pandemic? The compensation for taking risk that investors have enjoyed in the past is reward for accepting surprising things will happen – for better or worse. Avoiding event risk altogether is likely to be costly over time, even if on occasion it may – with hindsight – seem prescient.
Fighting the temptation to have a view
As we have discussed before in the context of Brexit, it is impossible to have an edge in systematically predicting an outcome of an event which is so highly scrutinised, let alone know how the market will respond. Nor is it enough to say: “this event is coming up and it could cause volatility”. You must consider whether the rest of the market is aware of this (hint: it is) and what is priced in.
Guessing outcomes, or trying to protect against the same sources of volatility that everyone else is worried about is unlikely to be time well spent.
This temptation is only compounded by working in an industry where there is an expectation for us to express views on such issues – from client meetings to press interviews, or on social media. The natural human desire to focus on the known risks is combined with the fear of how we will be perceived if we say that we simply don’t know. Yes, working in financial markets may mean that we spend more time thinking about some upcoming events, but so do those on the other sides of our trades.
The LBS professor Elroy Dimson defines risk in a succinct and insightful way:
“more things can happen than will happen”. For building robust portfolios, we should constantly remind ourselves that this applies at all times, not just around certain events which can often prove unhelpful distractions and damaging to investment returns – most obviously when we can have no edge in predicting their outcome.