For centuries, humans have tried to predict what was going to happen next. They sought out oracles and mystics, fortune tellers and psychics, and forecasters and models.
People crave certainty. We want to know what we’re going to get — what happens next. We don’t like surprises.
Yet, the market is inherently uncertain. It’s unpredictable. Nothing is guaranteed. It’s full of surprises.
The constant lesson of history is the dominant role played by surprise. Just when we are most comfortable with an environment and come to believe we finally understand it, the ground shifts under our feet. Surprise is the rule, not the exception. That’s a fancy way of say we don’t know what the future holds. Even the most serious efforts to make predictions can end up so far from the mark as to be more dangerous than useless. — Peter Bernstein
In fact, the market is so unpredictable that we only know what will happen long after the fact.
Does a 9% jump in the S&P 500 indicate the start of a new bull market or is it just another bear market rally? Are two bank collapses a one-off event or a sign of more to come? Do massive layoffs in tech foreshadow the end of an era for tech growth stocks or do the cost-cutting measures portend a new era of more efficient growth? Is the spike in inflation a temporary blip or is it a permanent fixture for years to come?
Unanswered questions abound because the market is extremely noisy in the short run and the future is unknown. Hindsight rules.
But that uncertainty leads to risk-taking by some and creates the opportunity to grow wealth. Investors must make bets on imperfect information to earn sought-after long-run returns.
There’s just one problem. Many investors would rather wait for the questions to be answered before putting their money at risk. Risk avoidance is the default when surprises arise.
That doesn’t mean your portfolio has to take a similar risk-averse stance. Here’s some food for thought:
- Uncertainty is the feature of a complex dynamic system. Nothing is more complex than the combination of businesses, markets, the global economy, and its 8 billion participants. Actions that try to control the system — reduce uncertainty — create unintended consequences. Solutions to “problems” in the system create new problems. Surprises happen.
- Market history tells us how often the unexpected occurs. The 2020 pandemic crash was the fastest ever, the fastest recovery followed, investor euphoria went into overdrive, SPACs became popular (also NFTs and meme stocks), a spike in inflation, a massive hike in interest rates, FTX fraud/bankruptcy, and a bank run were all surprises in the last three years. Surprises are the norm.
- Our views toward risk are often a byproduct of past experiences. For instance, anyone who lost money in the 2008 financial crisis might become more risk-averse after hearing about a recent bank collapse even though one event has nothing to do with the other.
- Surprises by their very nature are impossible to predict. Yet, that won’t stop us from trying. Nor does it stop us from relying on past market patterns, like historical asset returns, to set expectations about what may happen next. Good risk management weighs the possibility that those expectations are wrong and what the outcome might be. Always think about the consequences of being wrong.
- Diversification protects portfolios from numerous risks but it will never protect from every risk. The market is too complex to account for every possible outcome and the cost of doing so would destroy any returns in the process. Diversification is about tradeoffs. It means owning things that make you comfortable and uncomfortable at the same time. You have to accept some risk to earn long-run returns.
- We spend a lot of time and energy worrying about negative surprises. Positive surprises exist too. If you try to avoid the impact of one, you’ll likely miss out on the other. Positive surprises are a boon to portfolios thanks to diversification.
- The first rule of investing is to avoid permanent losses. Long-run returns may be the only returns that matter but investors need to survive the short run to achieve it. Diversification is one way to achieve it but it’s a partial solution. Managing yourself is the most important part.
Simple steps like proper diversification and managing your emotions while others panic is how to protect your portfolio and benefit from market surprises.
Source:
The 60/40 Solution
Related Reading:
Peter Bernstein: Embracing Surprise
Peter Bernstein: The Importance of Staying Power