2016 temporarily proves to be an interesting year in investment world. After long holidays in the West, the first trading day (Jan 4th) happened to be particularly interesting. After the event of executing Nimr, a Shitte leader in Arab Saudi, Iranian people were angry and attacked Arab Saudi’s Embassy in Tehran that invoked Arab Saudi, Bahrain, and Sudan to announce cutting diplomatic tie to Iran as a retaliation act within a currently very complex geo-political situation in Middle East. Investors in China sold a massive amount of shares in the first trading session of the year (down 7% in Shanghai Shenzhen CSI 300 and 3.9% in Shanghai Composite) after rumors that the government would lift the ban of stock sales that originally issued to administratively prevent the index to fall last year. European markets fell between 3-4% across major stock indices follow China and had the worst first trading day of the year in history. US market started trading in New York as the worst in 84 years with initial drop of 2%-2.5% of S&P and DJIA pre-market.
In Middle East alone, there are many developments that have the potential magnitude of a major global impact: (1) Syria’s civil war, (2) ISIS, (3) Terrorism in Europe, (4) extreme right wing’s shift of Europe political atmosphere, (5) Syria refugee crisis, (6) US-Russia conflict in casting soft power into Middle East after Crimea crisis, (7) Conflict between Arab countries and Iran (two largest oil OPEC exporters) as a symbol of conflict between the Shittes and the Sunni in the context of historic low oil price, and (8) Economic/diplomatic conflict between Russia and Turkey. The list above did not account for traditional conflicts and risks such as Israel-Palestine, Chinese-Indian border conflict in the East. Outside of the Middle East, China is both increasing geo-political influence to Asia (South China Sea, Hong-Kong, Taiwan) and Africa (Zimbawe adopts Reminbi as its official currency) and dealing to its own substantial economic risk that is more and more visible and can very well be the next tipping point for a crisis at global scale that might lead to shifts in geo-politics in Asia. North Korea declared testing H-bomb successfully (Jan 6th) that pushes conflict between this country versus South Korea and other East Asia countries to the next level. We can add conflicts between Russia and the West as well as Brazilian economic crisis to the list as well.
With these current global developments, what is the key development theme of the markets for 2016?
The answer is: I don’t know.
I follow a way of thinking in which 40% believe in consistently generating alpha by superior timing and selection/allocation and 60% believe in uncertainty and randomness that Efficient Market Hypothesis (EMH) tries to prove. The I-Don’t-Know school of thought is influenced by EMH, still, there are several critical implications to investors that are more practical to apply comparing to completely following EMH (such as Index Funds).
First, I-Don’t-Know school of thought following investors create a larger psychological room comparing to I-Know investors to accept all possibilities of the future as well as trying to not forcing their own subjective personal view into the objective developments of the market. This creates a more relaxed and humble stand, that deals with unexpected risks better than the I-Know investors. If I’m sure that Bank A’s cash depositing rate is 10% and Bank B’s cash depositing rate is 11%, no default as well as any other risks involved, then I will deposit 100% of my cash into Bank B. This example represents I-Know school of thought. Besides, there is no uncertainty in this example. Now let’s say I have the opportunity to invest into stock of company A with expected return of 25% annually and make angel investment into a group of friends (old friends, all have PhDs) that are making space rocket to Mercury and buy the first foreign currency denominated Mongolian’s government bond, deciding how to make capital allocation depends substantially from my own subjective view about how the future would unfold. Stock A may only achieve 5% return due to a conflict between Russia and Kazakhstan that affects company A’s business in exporting to Kazakhstan. The group of friends who do rocket science may create a bigger rocket after 10 times of failures that now can shoot it to Jupiter instead of just Mercury. Mongolian government may default on its obligation after the heir of Genghis Khan wins a historic election, decides to cut tie to global economy, and rebuilds their cavalry to invade North Korea. Only with these three opportunities, I am already quite unsure on how the future will unfold needless to say about how the world will unfold next year given its complexity. Thus, accepting to be “I-Don’t-Know” will generally make the investors wiser and avoid internal conflicts in decision making, being too hesitating or too aggressive, comparing to investors who follow I-Know school of thought.
Second, I-Don’t-Know school of thought will lead to a better risk managing practice by generally reducing sizes of each investing idea comparing to concentration as a key implication of I-Know school of thought. By proactively accept the market as unfathomable in absolute sense, the I-Don’t-Know investors will actively develop a defensive investing mechanism to deal with extremely rare and significant risks that is inherently unavoidable from the financial markets. Overall, these investors will neutralize betwen good years (with expected returns generally less than aggressive investors) and bad years (with expected returns generally better than aggressive investors). However, because extremely rare and significant risks can threat to survivability, these I-Don’t-Know investors believe they will generate better long-term compounding returns based on consistency in their decision making and investing method regardless of how future unfolds. Long-terms means 10 to 15 years and longer. This perspective can compare Warren Buffett’s returns to Hedge Funds’ returns, it’s rare for Warren Buffett to be the best performer in the market in any given year, but within 20-30 years, it’s rare too for any Hedge Fund to generate higher compounded returns comparing to Warren’s returns in relations to their implied risks. The reason is high achiever funds (such as funds with annual returns of 45% that result from aggressiveness would often be significantly exposed when the extremely rare and significant risks unfold, especially during crises as the case of LTCM).
Returning to the question: What is the key development theme of the markets for 2016? I think there is a great answer to that question and the answer will always be right even we change 2016 to 2026 or 2036, it is: Uncertainty. Uncertainty is the key theme of market development that I truly feel over the years since I engaged in financial markets. It is indeed higher every year, that strengthens my belief in investing defensively and risk managing actively will generate superior results comparing to investing aggressively. One note, investing defensively is different to defensive investing, the former is about mindset and the later is about strategy. Of course, there will be time the investors feel strongly about a market and there will be time the investors earn the right to be aggressive even though they follow I-Don’t-Know school of thought. Still, the investors who follow I-Don’t-Know school of thought will always be proactive in defending against risks even though they changed from defensive mode to aggressive mode – or defensively aggressive. That, I believe, in case the markets unfold really unexpectedly they can handle the risks that threaten their survival better and, more importantly, be more calm as they have always leave a large room in their perspective to deal with those kinds of risks.
6:21 AM – Jan 7th 2016, Portland, Oregon, United States
This article (Vietnamese) is originally posted on Timo.vn (Link) on January 19th, 2016