Wednesday, May 5, 2010

The Certainty of Uncertainty

Abnormal Returns has a great post about uncertainty and investing; a topic that has been on my mind of late due to the bomb scare, oil spill, natural disaster, and of course sovereign crisis (for anyone interested, I asked for / received help in understanding the potential for a Eurozone breakup back in January '09). To the post:

Alexander Ineichen writes directly to the issue of time diversification and uncertainty:
We believe time amplifies risk. It is true that the annual average rate of return has a smaller standard deviation for a longer time horizon. However, it is also true that the uncertainty compounds over a greater number of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon.

The logic here is that over the longer term, more bad things can happen and the probability of failure (i.e., non-survival) is higher. The probability, for example, of San Francisco being wiped out by a large earthquake over the next 100 years is much larger than over the next 100 days. If accidents happen in the short term, one might not live long enough to experience the long term. After all, the long term is nothing else than many short term periods adjoined together.
Ineichen uses the recent example of Japan showing that sometimes a market, even a developed one, can go down and stay down. The issue isn’t one of better estimating the equity risk premium or volatility of returns. It stems more from the fact that we really don’t know what the future holds. Recognizing the limitations of our statistical knowledge is a necessary step in facing uncertainty.
And here it is... the chart shows the Nikkei 225 index and the change from its previous peak (note that the chart does not include reinvestment of dividends). 20+ years and the index is still 70% below its peak.



An outlier right?

Well, it took the U.S. Equity market* from 1929 - 1954 (i.e. ~35 years) to re-reach its prior peak post Great Depression.



These "outliers" are important to keep in mind as the global economy has never been more inter-connected or had less "cushion" if an event were to occur (sovereign balance sheets were sucked dry during the crisis making any large bailouts [sovereign or banking] much more difficult going forward).

The result is that any little hiccup (in any part of the world) may have a far greater impact on the entire system than the market is currently pricing in. While it may not happen over the next day, week, month, or even year(s)... it is coming.

* the S&P 500 recreated by Professor Shiller to pre-date its 1957 inception

1 comment:

DIY Investor said...

The importance to me of these numbers is that there is a prevailing belief about the U.S. stock market that whenever it suffers a major downturn it will come back strongly. 2009 of course in just another instance that reinforces this belief.
Everyone is breathing a sigh of relief now but imagine if the market was down 15% from March 2009!
Your title is accurate.

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