Investing during extreme uncertainty


Investing during extreme uncertainty

Written by Paul Miron, Managing Director, Msquared Capital

As we return to work after a Federal Election and the appointment of a new government, there still seems to be no end in sight regarding the war in Ukraine…not to mention an energy crisis, world food shortages, supply chain issues…COVID-19…and rising costs of living, with persistent high inflation, and to top it all off – the prospect of further
interest rate hikes. It seems that our economic future has never been more uncertain. Or are things really all that bad for investors?

Amidst the macroeconomic upheaval in the global economy, the question of the day is, “How does one remain calm, continue to be invested strongly, and actually take advantage of these changes in the global economic cycle?”

It all comes down to understanding risk and aligning your investment decision-making with a rational disciplined risk-reward philosophy.

How Heightened Risk can Increase Market Awareness

An analogy can be drawn from a social experiment conducted some years ago in Drachten, Holland, by a traffic engineer named Hans Monderman.1 He removed all traffic signs, speed control, and traffic lights in this city. Naturally, you would expect complete chaos to have ensued. Almost completely counter-intuitively, both fatality rates and car accidents reduced, while traffic flows improved. Why?

It all comes down to personal risk assessment; when drivers have a constant level of heightened risk awareness, they become better judges of risk…more careful and prudent. Consequently, they become MORE cautious in an environment with fewer road signs and other traffic measures to falsely give you comfort and bombard you with colourful (but perhaps distracting) information.

Precisely the same concept applies to investing. When investors are constantly thinking about risk, being self-reliant and filtering through market noise cautiously, investor behaviour changes for the better, resulting in better investment decisions. 

It also demonstrates an essential truth about life and investing – risk is a constant – whether you are driving on a crowded highway or investing your hard-earned money.

What changes is both our attitude and reaction to risk. Suppose the market does not place a high value of risk on an investment. This investment will then become too risky as investors become more careless and speculative, thereby mispricing the asset. This results in a dislocation in the market, creating either an opportunity or a bad investment.

Macroeconomic Forecasts

Investors are often lulled into a false sense of security based on what other people are forecasting and thinking, meaning that they are often caught up in speculative investment
trends, often with undesirable outcomes.

I am astonished by the current significant economic events. We have not seen a sharper contraction in both stocks and property values for a long time.

The most pressing economic issue impacting all investors is the nexus between inflation and interest rates. How far will the RBA go in raising interest rates to curb inflation? This is now the centrepiece of all forecasts and market predictions. If rates are raised too quickly and aggressively, it increases the risk of an exceptionally prolonged recession. If our central bank is too lax, the inflation we are experiencing may morph into something more disturbing, such as stagflation, deflation, or even hyperinflation.

Thus, the question becomes: how reliant are we on forecasts when making investment decisions?

Below are the Big Four bank economists giving their best attempt at a forecast. Interestingly the CBA and financial market forecasts would differ significantly regarding overall asset prices, from notions of modest correction to a full-fledged
market collapse.

Taking the conservative estimate, if the CBA predictions are accurate, mortgage holders’ monthly repayments will increase by 14.6%,4 which is aligned with the last time we experienced a rise in the interest rate between 2002 and 2008. However, if they take the forecasts priced in by the financial market, mortgage payers would be making 39.7% higher monthly repayments.

Risk Tolerance

As per my last opinion piece, Msquared’s view is aligned with the CBA forecast; that is, we would anticipate property prices falling 15%. However, our risk tolerance towards new opportunities is more conservative as we continue to prioritise asset preservation. In other words, we have adjusted our risk profile to a more extreme decline in property prices, which is reflected in the opportunities we are providing our investors.

Our new opportunities reflect current forecasts as economists make their best market predictions based on the latest information. This takes into account the inability to predict
people’s behaviour or erratic future events.

To read Msquared Capital’s full article on investing during extreme uncertainty, click below to download the full report and learn more about the true fundamentals of investing.

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