Resist the overdramatic worldview

Humans are storytellers by nature and the stories that tilt to the extreme make us more receptive to them. Politicians and the media are fantastic at this and have been doing it for a very long time, since appealing to human emotion is the easiest way to win votes or to sell newspapers. 

The human brain is hard wired to simplify our choices by dividing things into two – good & bad, introvert & extrovert, truth & lie, optimist & pessimist and the list goes on and on…

In 1991, Howards Marks introduced the concept of the ‘Investment Pendulum’ which is timeless wisdom for anyone who seems to have an opinion on the financial markets. “In the world of investing, perception often swings from flawless to hopeless. The pendulum careens from one extreme to the other, spending almost no time at the happy medium and rather little in the range of reasonableness.”

For us reasonableness is looking at the world and financial markets as they are, not as we wish them to be. That’s our job summed up in one sentence.

Extreme optimism and incurable pessimism may seem to be complete opposites, but they both end in apathy.

Too Optimistic – In 2003 Nobel laureate, economist Robert E Lucas Jr said to his audience at the Presidential Address of the Economic Association: ‘My thesis in this lecture is that macroeconomics in this original sense has succeeded: its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.’ Few years later, that thesis was shattered by the discovery that the economy suddenly fell off a cliff.

 Too Pessimistic – Since last decade, many financial experts have been beating the drum of a recession through their bearish predictions which have been disastrously and undeniably wrong. Below is the chart from JP Morgan Asset Management which captures the extreme losses accumulated by investors would they acted upon the bearish claims in the last 10 years. Even the smartest analysts can be very wrong!

At some point in time, a perpetual pessimist will be rewarded with a recession just like a broken clock is right twice a day. To make one right call out of 20 is not an impressive track record and it doesn’t pay off. My personal issue with premature doomsayers is that their constant recession alarms could make investors numb to real risks. Doomsayers who stage things more urgent than they are, are boys crying wolf. We all know how it ends: with a field full of dead sheep. If the World was too frightened to invest, the World economy would die.

If both optimism and pessimism end up in apathy, then what’s the right approach? Legendary Statistician Hans Rosling provided the answer in his book “Factfulness” before he passed away in 2017.

 “I’m a very serious “possibilist.” That’s something I made up. It means someone who neither hopes without reason, nor fears without reason, someone who constantly resists the overdramatic worldview.” – Hans Rosling, Factfulness

This leads me to the biggest fear the world economy is facing in the short-term – Coronavirus

If there’s one thing that investors don’t like its uncertainty. Currently, the uncertainty is being driven by Coronavirus and more importantly, the unquantifiable damage this might do to World growth and investor sentiment. The impact of Coronavirus became much more tangible when Apple revised its revenue guidance downward, due to slowing down at its manufacturing sites in China and reduced demand from Chinese consumers. (Source: NASDAQ)

 China is still considered as the global factory of the World and the disruption to manufacturing and services due to travel bans will disturb the production and supply chains not just within China but throughout the World. There’s consensus with the experts that the Coronavirus is going to have deep impacts on the World’s GDP numbers. However markets look over this valley of pessimism.

No one is sure of the magnitude of the coronavirus outbreak yet. The scope of its impact on the economy is still almost entirely a guess.

Some health experts are arguing that Coronavirus is a classic Black Swan event. In my opinion, it doesn’t qualify for a Black Swan as the history of infectious diseases is as old as written history. Civilizations and the global economy have been profoundly shaped by infectious diseases. I provide below some brief data summarising the major pandemics of the past and present. Although this list is not exhaustive, it does however put things in perspective that we are certainly not dealing with a new problem.

 In the field of biotechnology, information is invaluable as the medical specialists have access to information on outbreaks from the past. It’s an unarguable fact science has advanced and we are much more equipped to solve the coronavirus problem today than we were 20-30 years before. The medical industry always finds a solution and wins the race. Doctors are not just relying on the luck to crack the problem; they have the insightful historical data to draw upon.

The death toll from coronavirus now stands at 2,800 reported as of 27/02/2020. (Source: Bloomberg) The death rate in Wuhan is between 2% and 4%, Outside of Wuhan, it is 0.7%. This means statistically that more than 99% of all people diagnosed do not die from coronavirus. Many other common infectious diseases such as influenza are much more deadly than this new-age fearful ‘coronavirus’. (Source: World Health Organization)

A further 650,000 deaths occur annually from simple respiratory diseases, according to estimates by the United States Centre for Disease Control and Prevention (US-CDC). (Source: WHO Article, Up to 650,000 people die of respiratory disease linked to seasonal flu each year).

When an uncertain event happens, investors tend to focus their attention on that single event and it’s absolutely worst-case potential impact. Taleb recommends in his book Black Swan –“To be able to focus is a great virtue if you are a watch repairman, a brain surgeon, or a chess player. But the last thing you need to do when you deal with uncertainty is to “focus”.

Taleb is reminding us to not lose the big picture view of the larger order instead of looking at the world from the tunnel vision of coronavirus.  UBS Emerging Markets Portfolio manager Geoffrey Wong argues the bigger concern than the coronavirus is the extreme unprecedented precautions taken by people and its impact on economic activity.

Thanks to global media freedom with seamless information flow, we hear much more about disasters than ever in the past. We are mindful of the fact that our surveillance of suffering has tremendously improved and it could inaccurately lead many of us overestimating the risks.

My intent for this note is not to downplay the risks coronavirus poses but to encourage investors to see this single event for what it is. A minor single event within a long-term investment cycle. There is no need whatsoever for panic.

There’s market precedent that the best and worst days in markets tend to appear together, making it almost impossible to time the market. DALBAR Inc. provides the most compelling research into the self-inflicting investor behavior by computing a 20 year average annual compound rate of return of the index and also the average return realized by the average equity investor. 20 year annualized returns through GFC (1998-2018) for an average equity investor were 5.29% p.a. in comparison to the index returns of 7.2% p.a.

I find it alarming that investors behaviorally evaporate 30% of the returns generated by equity markets by trying to time the market. By doing this, they underperform not just the market but their own investments. More money is lost due to fear and greed than all of the economic and geopolitical events combined.

This 30% loss doesn’t get as much attention of the media and newspapers as the insignificant market corrections do.

We live in a world where information spreads like wildfire and intensifies the market volatility. Hence, the significance of long term investing cannot be overstated. Investors are rewarded for sticking to their investment discipline by riding out the worst days over time. It may seem prudent to wait for the bad days to pass before entering the market, but it also means missing out on the best days.

As always, it is important during times like these to remain calm and to try to take human emotion out of your investment process. Equity markets are constantly pricing on what they believe will happen in 12 months’ time not what is happening today. When this function breaks down it actually presents opportunity.