The impotence of the counterfactual

Managing risk is the most thankless job in finance. It’s like working in IT. If things go wrong, everyone comes and blames you but if things go well, nobody comes and says thank you.

A main feature of investing is that you cannot try out new ideas in a laboratory and perfect them there until they are ready for the real world. You have to try investment ideas in the real world. This also means that things not only can but will go wrong. The job of an investor is to protect the portfolio from unwanted or excessive losses.

The problem is that managing risks and protecting a portfolio comes at a cost. If you hedge a portfolio with derivatives, costs will be incurred. If you reduce risk with lower risk investments, you typically face lower returns. And if you diversify risks properly, you will end up with investments that perform worse than your original investment (if you don’t, chances are your “diversified” will not protect you when markets turn sour).

All of this seems obvious in theory, but the problem is that if you protect against risks and the risks never materialize, you are left with lower performance.

Assume you expect a recession to hit the US in 2020. What can you do? You can reduce your stock holdings and replace cyclical stocks with defensive stocks. Or you can shift from stocks into bonds. Or you use options and futures to hedge your equity exposure, etc.

If the recession materializes and stock markets tank you feel pretty good about yourself and your decision to reduce risks. But what if the recession never comes and the bull market continues?

Over the last decade, many people have predicted a recession in the US that never came:

  • In the summer of 2011 Europe was in the midst of a debt crisis and the US was at the brink of defaulting in its debt over a debt ceiling standoff in Congress. Stock markets corrected but recovered quickly again.

  • In late 2015, oil prices tanked in the midst of a supply glut and a Chinese growth slowdown, yet the US economy and the bull market in stocks continued with few setbacks.

  • In 2016, Donald Trump was elected President and some people expected an imminent recession. Yet, once again, nothing happened.

Every time it would have been rational to protect your portfolio against market setbacks and every time, the investor would have looked stupid in the aftermath.

But nobody ever asks the “what if” question. What looks like unnecessary defensiveness might have turned out to be the right thing to do if the world had taken a different turn. People that are today celebrated as investment heroes because they had stayed invested in risky assets all the time would have been criticized as reckless, while people who are derided as too cautious or bearishmight be the stars of today.

Take the case of GMO. For years, the company has warned of high valuations and the possibility of a market bubble that may burst at any time. As a result, the portfolios of the firm were probably more defensively positioned than other asset managers and their performance was weaker than their competitors’. Does that make them worse asset managers? 

Well, they warned of overvalued markets in the late 1990s and turned out to be right (though about two to three years early). In the early 2000s, after the tech bubble burst, GMO was hailed as the firm that saw it all coming. Had the bull market of the late 1990s continued a few more years or the current bull market ended a little bit earlier, the public perception of GMO would have been 180 degrees different. 

The same portfolio and the same asset manager but a vastly different public assessment of their skill. If you criticize GMO for their caution today, you ignore the counterfactual. If you praised them for their caution in the early 2000s, you did the same.

The longer a bull or bear market lasts, the more impotent the counterfactual becomes because more and more people who bet on a reversal of the markets (either from bull to bear or from bear to bull) look stupid and will be derided by other investors as people who don’t understand this market

Of course, the counterfactual is not less likely ex ante than the actual outcome. And investors need to position their portfolios before an event, not with the benefit of hindsight. Thus, the most dangerous thing we can do today - after a bull market in equities that lasted more than ten years - is to ignore the counterfactual and focus on just one scenario. Whether you are bearish or bullish, the most important question to ask is: “What if I am wrong?” How would you position your portfolio then? And if the answer is vastly different from your current portfolio, what makes you so sure you are right? As Robin De Niro says in the movie Ronin:

“Whenever there is any doubt, there is no doubt.”

And if there is a reasonable doubt about your expectation for the future then it is better to stay away from extreme positions, be they extremely bullish or extremely bearish. Today is not the time to be all in on equities nor is it time to sell all your equities. 

In fact, it is never time to be all in on equities or to sell all your equities because the future is never certain. And neither you nor your portfolio should ever be certain about the future either.