People tend to be uncomfortable dealing with investment decisions at the best of times. Yet current uncertainty about geopolitics, economics and sharemarket valuations can lead to a retreat from investment decision-making altogether.
Over the past year, Brookvine led discussions around uncertainty with institutional, family office and private wealth investors. Participants at the various forums generally agreed that the most effective decision-makers under uncertainty require low anxiety, patience and a tolerance of ambiguity.
They also acknowledged that risk and uncertainty are easily confused.
Measurable uncertainty is known as risk, about which we have a reasonable understanding. Uncertainty (also known as ambiguity) is reserved for the non-measurable type, about which we have almost no understanding. Uncertainty thus compels investors to rely on heuristics (sometimes called 'rules of thumb' or commonly-accepted rules) in making decisions. These refer to practical, somewhat loose rules that guide us towards the ‘better’ and away from the tyrannical search for the ‘best’.
Most popular strategies
1. Margin of safety
Perhaps the most renowned heuristic is the margin of safety. Investopedia defines it as ‘a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value’. It is what anchors the beliefs of investment titans like Warren Buffet and a long lineage of value investors.
The participants generally felt that the margin of safety needs to be enhanced when faced with uncertainty. It is likely that most of us instinctively feel this way. This notion was reflected in a retreat from global sharemarkets, prior to the fourth quarter 2018 downturn, by some forum participants.
2. Delaying
Delaying until there is greater certainty is another common approach. It reduces anxiety but increases the opportunity cost. Avoidance may later be viewed as an error of omission, but such errors are rarely judged as harshly as errors of commission.
3. Winning by not losing
A form of winning by not losing also appealed to participants with a pessimistic bias. You might consider the down-side case for all investment opportunities and favour the ones that are least likely to lose.
Some contrarian strategies
Some bold and well-informed investors adopt contrarian heuristics. They fix on those opportunities that are completely out of favour, and better still, are temporarily beaten down by a considerable margin. They know that the best investment opportunities often arise when you buy from a ‘forced’ seller.
4. Rebalancing
Some heuristics embolden contrarian behaviour. Rebalancing is the process of realigning weightings to maintain original desired allocations. It diminishes drift away from desired targets as disciplined rebalancers sell what’s hot and buy what’s not. Heuristics may deal with the frequency of change and the level of misalignment prompting change.
5. Conviction
Investors with a strongly-optimistic bias may seek to maximise their pay-off by investing with conviction. Heuristics that corral your best investing ideas and promote more concentrated positions amongst a smaller set of individual securities found strong support amongst the participants.
Taking a dip, or following others
6. Toe-in-the-water
The toe-in-the-water approach was familiar to many of the participants. It is useful in conjunction with delay. Often many toes remain dry, resulting in minor allocations with immaterial impact and a consequent larger opportunity cost. But, a toe-in-the-water allows an investor to prove up and grow familiar with new investments before allocating more.
7. Co-investing
Partnering or co-investing with someone who has complementary or even better skills, experience and opportunities is appropriate for investors with access to these skill sets. Investor syndicates and managed funds are the mainstay for a partnering approach.
8. Following-in
Following-in is common. Any investment opportunity will have its early adopters, fast followers, late movers and naysayers. For new and unproven opportunities, drawing confidence from the calibre of the early adopters and fast followers is common.
Diversifying, alternatives and selecting managers
9. Diversification
Heuristics regarding the level of diversification are open to debate between entrepreneurs (who made their wealth by not diversifying) and accumulators (who want to grow steadily and do not want to lose theirs). Warren Buffett famously said that:
“diversification is protection against ignorance; it makes little sense if you know what you are doing.”
Diversification controls the risk that our conviction is misplaced. More rather than less is often best, more so for those lacking a prepared mind, a good investing instinct and patience.
Most participants argued in favour of more alternative investments to enhance diversification and improve returns. These include hedge funds, private equity, private lending opportunities and niche strategies in mainstream asset classes. However, there are major uncertainties around so-called alternatives. As one participant noted, alternative strategies with greater reliance on managerial skill can be fickle, so hence, as a general heuristic, you want to diversify across more strategies in alternatives than in mainstream asset classes.
10. Good hygiene in fund manager selection
Hygiene heuristics for managed funds, conceived to quickly relieve uncertainty about competing investment choices, led to a range of rules of thumb:
a) a manager’s own investment in their fund (meaningful is best)
b) degree of independence (prefer independently owned, unlisted firms)
c) level of client retention (high)
d) nature of their client base (long term, informed investors)
e) size of their funds under management (not excessive)
f) culture (small is beautiful)
g) focus of their activities (single discipline better)
h) turnover of their investment team (low).
Savvy investors in other asset classes, like direct real estate and private companies, often apply a set of hygiene heuristics of their own.
Past performance heuristics often rely on being able to take a quick look behind the results as numbers can lie. For example, it helps to be able to discern the positive or negative impact of a bias favouring value, growth, large or small stocks. Disaggregating results between good and bad years is another step towards making better decisions in light of annualised share portfolio returns.
A prepared mind is vital
Of course, rules and approaches may vary greatly by investment type and strategy. For all of this, a prepared mind is a godsend. This can be achieved by playing with (not planning for) conceivable, if highly unlikely, scenarios and their outcomes. It is bolstered by a critical reading of broad history and a keen awareness of investing in times past.
Steven Hall is the CEO of Brookvine and a passionate advocate of alternative investment strategies. Dr Jack Gray has been a Director and Special Adviser at Brookvine since 2008. Jack is also currently an Adjunct Professor of Finance at the Centre for Investment Management Research at the University of Technology, Sydney.
The content in this article has been prepared for general information only without considering the investment objectives, financial situation, or needs of any individual.