Embrace Uncertainty: The Emerging New Normal is Not So New

Amit Sinha

A key lesson emerging from the COVID-19 pandemic is that far too many for too long have overestimated the certainty of outcomes.

It seems today that there are many who tend to over-estimate the certainty of uncertain outcomes and make decisions by unconsciously assuming a particular outcome to be 100%. Such overestimating of certainty can lead to poor decision making by ignoring other probable outcomes.

A probabilistic approach can result in superior outcomes. As Rory Sutherland points out, bees tend to achieve superior outcomes in finding pollen by having a small number of “R&D bees” explore at random, seeking pollen and nectar from sources as yet unknown. Approaches such as simulated annealing and genetic algorithms tend to identify optimal solutions by allowing for randomness while converging upon a solution.

As we go through what is likely the most profound social and economic event in our lifetimes, embracing a probabilistic approach is essential to portfolio design.

On one hand, we are facing:

  • The largest global pandemic in 100 years
  • The greatest economic contraction and job losses in 80 years
  • The greatest oil price decline in decades

While at the same time we are experiencing:

  • The largest central bank and government intervention of all time
  • Unprecedented global coordination and collaboration to identify a medical solution
  • Rapid discounting of future outcomes, as reflected in one of the sharpest drawdowns and recoveries in capital markets within a two-month period

How these events impact the real economy, coupled with the reaction function of consumers, policy makers and investors over the next several years cannot be forecasted with complete certainty. From a benign recession, a strong recovery, or a prolonged downturn, to contained or runaway inflation, to a more cohesive or divisive society, all are outcomes with non-zero probabilities. The answer to where the future lies is unknowable – the best we can do is make educated guesses.

Guessing may not be such a bad thing. In the face of higher complexity, a portfolio that reflects the central tendency playing out with certainty may not be desirable. Such a scenario puts in an unfamiliar and perhaps even an uncomfortable place - thinking probabilistically when our natural instinct is to be deterministic.

How to embrace probabilistic thinking in portfolio design?

Most return-seeking portfolios have a bias toward positive growth and low inflation, expressed primarily through long beta positions in equity, credit and duration. In a productive global economy, over the long term this is the most likely ‘steady state’ environment. However, this central tendency can be balanced by adding diversifying return streams with a payoff profile that is different from traditional sources of returns. Similar to ‘R&D bees’, diversifying strategies can explore sources of premia that provide a convex payoff in different scenarios.

An ancillary benefit of greater uncertainty is risk premia, i.e. the compensation an investor earns for taking on greater risk. While one may not be able to predict which scenario might play out in the future, diversifying strategies can provide a portfolio with staying power and potential excess returns that may be orthogonal to long beta positions.

Three guiding principles can help investors identify appropriate diversifying approaches:

  • Recognize that there is no magic bullet – all returns are compensation for risk
  • Define scenarios that impact your portfolio, and desired outcomes within those scenarios
  • Factor in the level of uncertainty and acceptable trade-offs

The COVID-19 pandemic and associated policy actions are going to have lasting effects on how we as individuals and as a society work, play, live and communicate for years to come. The consequences of this experiment are uncertain. Probabilistic portfolio design and diversifying strategies can help expand investors’ toolkit.

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References:
https://www.ncbi.nlm.nih.gov/pubmed/19145027
https://degreesofcertainty.blog/2019/04/19/rory-sutherland/
https://en.wikipedia.org/wiki/Simulated_annealing
https://en.wikipedia.org/wiki/Genetic_algorithm

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