When we survey the economic landscape in South Africa today, we observe much pessimism about the future, precisely because so many areas face uncertainty and risks.
In the prologue to his book Antifragile, Nassim Nicholas Taleb says, “You want to be the fire and wish for the wind.” We are not sure if Cape Town’s firefighters would be saying the same after the devastating fires that recently occurred. The point he makes though is relevant for us in financial markets, which is that we do not want to hide from uncertainty, chaos and randomness, as he puts it, but to embrace it and benefit from it. When we survey the economic landscape in South Africa today, we observe much pessimism about the future, precisely because so many areas face uncertainty and risks. Over the past year we entered the Covid-19 pandemic, only adding to the misery. The deterioration in our fiscal sustainability has been painful to watch, and the ructions in the governing ANC have created angst in those who look to the public sector to provide comfort.
If we are to follow Taleb’s advice and embrace risk then, we do not want to do so as a firefighter who goes into battle with nature without any protective gear. No well-trained firefighter would take such an approach. Firstly, having an understanding of one’s foe is crucial. In financial markets we too often see an inherent pessimism about the future, and this is one of the first mistakes that investors make – using a linear approach to problem solving, which is to assume that events occur in a linear fashion when the truth is that nonlinearity is the prevailing paradigm. For the firefighters, their nonlinearity was the wind. What started out as a northerly wind driving flames towards UCT, ended up changing overnight into a raging southeaster, threatening the urban edge in the City Bowl in the opposite direction. Likewise, in markets and economies, the arrival of a once in a century pandemic in 2020 up-ended all expectations and forecasts. Our notion of what is normal has been completely altered.
In a nonlinear world, investing for the future is an inherently difficult thing to do successfully. Let’s look at an example : If we had only invested in tech stocks over the past 20 years, we would have been enormously successful, and the temptation would be to say, “If it ain’t broke, why fix it?” It’s hard to argue against 20 years of data points. Just as very few would have argued a year or two back to avoid airlines because a time was coming when there would be no flights, it would likewise be very hard to argue that one should avoid all tech stocks because some way down the line a cyberwar or attack will erupt that will close down internet connections for months on end. One cannot though look at future scenarios and then decide to avoid all risk.
This almost always points us to 3 basic principles to embrace in a sound investment portfolio that balance risk and return:
Diversification. Embracing risk without knowing the future means having exposure to different risks. It is one of the reasons why gold (and yes, even cryptocurrencies) invariably comes up as a key portfolio component, because of their lack of correlation to other economic fundamentals. This is a crucial way to reduce total risk. Being exposed to tech was great during the past year as the market favoured the resilience of their business models during the pandemic, but at some stage, airlines are going to be making a killing as normality resumes and pent-up demand for travel is released. And so it goes…
Inflation. Don’t ignore inflation – always be aware of how a portfolio of assets protects against inflation and does not necessarily rely on past returns as a predictor of future returns. If necessary, an explicit exposure to inflation-linked bonds can be used. In South Africa for example, government issued inflation linked bonds are trading at real yields of over well over 3%. This is a great long term investment opportunity.
Avoid get-rich quick schemes. It may sound obvious, but falling for a fad or a get-rich-quick scheme because you think it fits into Nassim Taleb’s “embrace risk” strategy, is well, just dumb. This is where the old saying of “If it sounds too good to be true, it probably is” is very relevant. Basically it means that you have to do your homework, as good returns don’t just fall into your lap. A sound and systematic approach to making investment decisions is a necessity.
No fire-fighting team sets out without a plan and a strategy, plotting a way to embrace the terrain, the wind and the vegetation in that strategy. Similarly, no investor should be plotting an investment course without due consideration for balancing the risks, which include the oft-forgotten liquidity risk, with the possible returns, and it also implies that a returns-only focus is likely to ultimately lead you into a fire somewhere along the line. With that in mind, a salute then to our long-suffering firefighters across the country!