Tuesday 28 February 2017 3:33 pm Schroders Talk

Two ways investors can cope with uncertainty

What is city talk? Info Info. Latest
I’m an author on The Value Perspective blog and a fund manager on the value team at Schroders. Prior to joining in 2015, was responsible for the UK research process at Threadneedle. I began my investment career as an analyst in 2001.

I’m an author on The Value Perspective blog and a fund manager on the value team at Schroders. Prior to joining in 2015, was responsible for the UK research process at Threadneedle. I began my investment career as an analyst in 2001.

  The lead character in Up may have coped with the randomness of life by travelling the world in a house powered by helium balloons, but investors can make use of a couple of more conventional techniques

“Daddy, why is the man crying in the hospital?” “Daddy, where has the lady gone?” “Daddy, why are your eyes watery?” These were all questions my son asked me as we watched the first 10 minutes of the Pixar movie Up. If you have seen the film, you will immediately know what I am talking about. If you haven’t, you can catch the clip here. Don’t forget to have a hanky ready.

The film’s opening montage deals with some of the most difficult issues we face in life – notably, serious illness, death and coping with bereavement. Not the most promising start for a light-hearted animation primarily aimed at children, you might think, but they are unusually clever people at Pixar – as can be seen from the thoughts of one of the company’s co-founders on the subject of dealing with randomness…


“Here’s what we all know, deep down, even though we might wish it weren’t true: change is going to happen, whether we like it or not. Some people see random, unforeseen events as something to fear. I am not one of those people. To my mind, randomness is not just inevitable; it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised.” Ed Catmull, Creativity, Inc.

Catmull’s quote drills right to the heart of the complicated concept of uncertainty – of risk – that is such an important part of the world of investing. And, to echo Catmull’s last line, acknowledging the nature of risk is a crucial first step for any investor.

What is risk?

Many investors feel the greatest risk is how much a share price bounces up and down over any period of time — its volatility. We think about risk differently. We focus on the risk that lies within individual businesses and specifically two ‘fundamental’ points:

  1. The true worth of a company’s assets
  2. How much profit a company can make (in normal market conditions)

The risk for us is if these two ‘fundamentals’ change permanently from where we expected them to be when we invested in a company. No one can predict the future; this is something we are keenly aware of. Often these fundamentals do change, but our awareness that change happens means we prudently plan for it.

How to cope with risk and uncertainty?

1. Margin of safety

Margin of safety (or margin of error as some say) describes how much the fundamentals of a company can change before the price you paid for its shares proves to have been too expensive.

The great investor Warren Buffett has explained the idea of ‘margin of safety’ with the analogy of a bridge:


You’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle. If the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.

For a more detailed explanation this Business Insider article is a good read.

Translating this into investment, we want to ensure we purchase shares a low enough prices to allow for this uncertainty. The riskier we think the investment might be, the higher margin of safety will be needed.

2. Diversification

Most investors diversify – that is to say, rather than ‘putting all their eggs in one basket’, they create a portfolio from different types of asset. It is one of the more straightforward approaches to investing but also a tacit acknowledgement that you can never predict what is going to happen.

Building a single story around what might happen may make the future feel more certain but such an approach will leave you out of touch with reality and prone to making mistakes. For our part, since we are well aware we could be wrong, we only take small positions in companies. This diversification not only means the decisions we get wrong should not unduly hurt our performance – they should also be compensated for by the ones we get right.

To help drive home our philosophy I’ll leave you with another quote from Catmull:

“Fear makes people reach for certainty and stability, neither of which guarantee the safety they imply. I take a different approach. Rather than fear randomness, I believe we can make choices to see it for what it is and to let it work for us.”

The world is an inherently complex and uncertain place and so, as Catmull says, striving for certainty and stability does not guarantee we avoid risk. Up may tell us we can strap a load of helium-filled balloons to our house and the wind will blow us wherever we want to go. Its bigger and more important message, however, is that things do not always turn out as we planned. It is how we deal with that which matters.

  • Andrew Evans is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

Important Information: The views and opinions contained herein are those of Andrew Evans, Fund Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

 

Share