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Are we playing chess or is it chaos?

15 Sep 2021 8 month(s) ago

Conventional investment analysis is like chess moves, but is that the game we are in?

Investment analysis is extremely sophisticated and a bit like learning to play high level chess. The pieces are things like shares, property, bonds, gold and, more recently, cryptocurrencies. Analysts, aiming to be like chess masters, and often possessing very high intelligence, attempt to devise strategies that will beat the herd.

More often than not the results are patchy, at best. After all, any one analyst is up against milions of other investors applying their collective knowledge about value. But perhaps the greater risk is that we are starting not to play chess any more. What if the stress to the whole system – the chess game – is getting so great that the rules may not hold? Will mere anarchy be loosed on the financial system?

In such an environment chess strategies will not help like before. But it may still be possible to apply some of the common sense insights learned over decades. For example, stock markets will always be volatile, which must be accepted by investors. It is a truism that markets regularly fall by 50 % and any investor who is exposed to markets should have prepared for what is known as sequence risk: the risk that negative returns will be incurred if the investment is withdrawn whenever there is a sharp downturn.

Such price collapses mask the fact that, over time, shares usually do better than other types of investments. Concluding that big corrections are a reason to stay out of the stock market is a recipe for poor performance returns. Rather, the challenge is to be prepared. 

What experienced advisers usually point to is something akin to a fire drill. Crises, like fires, will hit and it will usually hit when most are unaware. In 2008, when the global financial crisis hit, investors who maintained their allocations benefited from a strong recovery.

The future of markets is unknowable and there will always be sharp, and sometimes dramatic, downturns. But to the extent that such things can be anticipated, low volatility portfolios usually do better. Consider two portfolios that both give average returns of 10% a year over a ten year period. One is a low volatility portfolio, which has a standard deviation (deviation from the norm) of 4.5 %. The other is a high volatility portfolio, with a standard deviation of 18.6 %. The low volatility portfolio produces a compound return of 9.9 %, and the high volatility portfolio produces a compound return of 8.5 %.

But an analysis such as that is still looking at investment as a chess board, working out the best moves within a stable set of rules. Trouble is, questions are being asked at the most basic level: what is money? Does conventional fiat currency have a future with so much debt? Should the mountain of derivatives, $US600-1000 trillion, be called money? Will there be Central Bank Digital Currencies replacing conventional money? 

These are all questions from outside the chess board, a world of new, possibly chaotic, rules. Being a grand master in such an environment will not necessarily be an advantage.


Reader note: This is general reporting only and should not be considered in any way to be investment or tax advice. It does not take into consideration the investment objectives, financial situation or particular needs of any particular investor. For more information please read our disclosure statement.

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