Amongst my rather small group of clients and at dinner table conversations with family and friends I keep getting asked on what is going to happen next to the world economy, where are the Indian markets poised? The implications of Brexit, the Chinese market crash, and the impending rise in US interest rates. As an investment adviser, it is expected that I should have the intelligence or the clairvoyance to know what is going to happen next. As succinctly put in this article by John Tammy in the Forbes magazine:
a market crash is the result of new information entering the market place, not what you, me and the pundits already know. Markets could very well crash one week or one year from now.. ..but if they do it will be for reasons that have next to nothing to do with commentary coming from crash-obsessed attention seekers in the punditry.
Nassim Taleb coins the term 'Green Lumber Fallacy' in his book Antifragile. Referring to the book - “What I Learned Losing a Million Dollars”, he points out that an encyclopedic knowledge of green lumber was not necessary for Joe Siegel, a trader in green lumber to make a fortune. So ignorant was Joe Siegel on green lumber that he believed green lumber was wood painted green when in fact it was simply young, freshly cut timber. He goes on to illustrate many more cases where the people making pot loads of money were trading in stuff they knew next to nothing about. The point being made is that knowledge of something and making money on it are not the same thing.
What I am getting at is that all the punditry in the world does not necessarily convert itself into a robust portfolio. What is probably more important than knowledge (which time and again has proven a poor predictor of future outcomes) is the idea of creating optionality in portfolios. So the question should not be “What’s going to happen?”, but rather “What should we do now?”. In a long only portfolio such as what I advise upon, having large and liquid cash buffers is one way of creating optionality. These large cash buffers insulate portfolios (at least partially) against large drawdowns and provide the ability to act upon low prices when the opportunity presents itself. Make no mistake that there is a cost to this optionality. The cost is that our portfolios are not optimized for maximizing return in rising markets. Cash brings in a redundancy, which in rising markets will pull down portfolio performance. We accept this redundancy since we do not mind losing a battle (short-term returns) and stay fit enough to win the war (long-term returns).