The Importance of Weighing Probability and Consequence

Share this article

U.S. equity investments have grown at roughly a 10% per year rate over more than two centuries.  Over that span, this country has evolved from a frontier economy to the most powerful economic force the world has known.  Given our entrepreneurial spirit and still substantial economic freedom–notwithstanding growing regulatory burdens–there is no reason to doubt that the United States will continue to make great economic strides in the century ahead.

Despite impressive long-term economic and stock market progress, recessions and bear markets have interrupted the upward march with considerable frequency over the decades.  Were it not for those inconvenient and sometimes long-lasting interruptions, buying and holding a portfolio uncluttered by anything but common stocks would be the optimum prescription for most investors.  Obviously, it’s not that simple.  Only this year did the S&P 500 rise above its level of early 2000.  Most investors, especially those in or near retirement, could not easily ride out the roller coaster pattern that has unfolded since the turn of the century.  While the economy and markets have survived the turmoil and have risen to new highs by many measures, there was no certainty that would be the outcome to the 2008 crisis.  As has been widely admitted, the world financial system was in severe danger of completely shutting down before the Federal Reserve and Treasury implemented their still ongoing monumental rescue programs.

Based on two centuries of history, investors in 2008 would have been betting with the probabilities to simply ride out the storm and continue to hold their equity portfolios.  In fact, that strategy would have proved profitable.  On the other hand, the consequence of a failure of the experimental government rescue programs could have led to a collapse into another depression, according to those charged with dealing with the crisis.  If the same scenario had been played out 100 times, rather than just once, the outcomes would likely have been quite different a good percentage of the time.  Historically less probable and more destructive outcomes would undoubtedly have occurred several times.

That is a relevant consideration for investors today.  Probabilities still argue that stock prices will continue to rise in the long run.  Most investors, however, are uncomfortable simply riding out occasional lengthy price declines.  Almost no investors are willing to risk a collapse of the financial system, as nearly unfolded in 2008, unbeknownst beforehand to most investors.

While it is clear that government largesse has replenished bank capital, government debt levels have exploded over the past five years.  Regardless of long-term positive return probabilities, there remain very real possibilities of major systemic collapses.  Entire countries in Europe and banking systems that hold their sovereign debt remain in jeopardy of default.  Detroit could be the first of many cities and states in this country that cannot pay all of its bills.  Will the related central banks be willing and able to bail them out?  Will investors retain the requisite confidence in these central bankers, allowing them to provide a worldwide safety net?  Confidence can be an ephemeral thing, and no one can guarantee that such confidence will remain firm.  A possible consequence of failed confidence in the ultimate economic and market saviors is an economic and market collapse at least as severe as those already suffered twice in this still young century.

If you have a multi-decade time frame and patience to withstand even the worst market declines, you can play the long-term probabilities and stay fully invested.  If, on the other hand, you are like the vast majority of individual and institutional investors, neither your time frame nor your patience extends far enough.  The consequences of failed central bank rescue efforts would be unacceptable, and must be avoided.

We have urged those in the latter camp to abandon the traditional buy and hold approach for the bulk of their investment portfolios.  For our clients we have adopted a formularized equity allocation process for an appropriate portion of each portfolio.  While the process certainly cannot remove all risk, it has provided strategic and profitable equity exposure.  At the same time, the components of the process are designed to dial back equity exposure based on readings from time-tested defensive criteria.  We strongly encourage all investors who could not withstand strong negative consequences to reduce their long-term risk exposure and to find a strategy designed to keep all equity exposure within their sleep-at-night tolerance.