Like an over-populated gym or a list of resolutions, market outlook documents are one of the most reliable signs of a new year. Many are well written and beautifully produced with valuable data for those helping investors save for the future. However, they are also a scourge of the investment management profession and a demonstration of our failure to understand the key challenges we and our clients face when investing.
This view may appear incongruous coming from someone who has spent most of the last six weeks talking about our own outlook document and so I should reassure you that this rather strident view does not reflect any weariness of these conversations or frustration that investment outlooks are ubiquitous. Instead it raises a concern that our profession has fallen into the trap of viewing investment from a capital markets perspective, rather than from the investors standpoint.
Investment outlooks typically focus on what will happen to asset prices over the year ahead and present well-formed narratives of the future. These narratives are designed to encourage the belief that a particular asset manager is blessed with an unusual degree of prescience that is deserving of the clients’ capital. Unfortunately, the last few years have provided the perfect case study of the failure of investors to predict the key drivers of asset price movements and the consequent sterility of such forecasts.
This failure is a feature of investing rather than a bug in the system. One of the most challenging aspects of being an investor is to accept is that the future is genuinely uncertain. Uncertainty was defined by Frank Knight in his 1921 book “Risk, Uncertainty, and Profit” and describes a situation where both the outcome and the range of possible outcomes is unknown. This differs from Knight’s definition of ‘risk’ which is a situation where we don’t know the outcome but we know the range of possible outcomes. The latter describes the situation in a casino, while the former characterises investing.
Faced with the unsettling implications of an uncertain future, it is unsurprising that so many professional investors attempt to tame uncertainty with complex risk models and transform these models into stories that that drive the allocation of an investor’s capital. However, our perspective changes dramatically when we embrace uncertainty. If the future is unknowable, our focus must shift from predicting near-term movements in capital market prices to the behaviour of the investor and, in particular, their response to surprises.
We know that the biggest risk to an investor is that they cease investing, with ‘performance chasing’ coming in a close second. We also know that investors are more likely to exhibit these behaviours when they are surprised and therefore our first priority must be to reduce the incidence and impact of the surprises implied by an uncertain future.
As we think about investing from the perspective of the client, we see that the role of the investment communications, such as an outlook, is no longer to create narratives, but rather to help the investor stick to the plan and remain invested in a well-structured portfolio that reflects their goals and risk profile. In this context, the key purpose of an investment outlook is to address the concerns of the investor, prepare them for a range of possible outcomes, and give them confidence in the act of investing. This latter point requires a long term perspective.
While we do not know what the future holds and we cannot accurately predict how asset prices will change in the short run, investing enables us to participate in the success of human innovation and productivity. The act of investing is therefore an expression of confidence in the ability of humans to adapt to the future as it unrolls before us and to overcome the hurdles it presents to us.
Over a reasonable investment horizon, the price of the assets we own are likely to reflect that success and consequently, the returns we receive will depend upon the price we paid for them relative to their ‘fair’ value. The lower the price we pay, the higher the returns and vice versa. Unfortunately, many investors naturally have the opposite perspective: the higher prices are, the more optimistic they feel!
The role of capital market analysis in an outlook document is therefore to counteract the self-defeating instincts of investors and help them make better decisions on their journey towards their goals.
This client-centric approach enables us to winnow-out the majority of the outlook documents and accompanying invitations that arrive in our inbox at this time of year. The time we save can then be used far more profitably understanding the challenges our clients face and considering how best we can keep them on the path towards their goals.
Dan Kemp is global chief investment officer at Morningstar Investment Management