At times like these, it can start to feel like the world is nearing a tectonic shift that will see a reset in its prevailing order. This degree of change is sure to be overwhelming and trying to understand the path and significance of it all can seem insurmountable.
While navigating through the volatility of our current environment, thinking about investments – which are predicated on discounting the future – feels particularly challenging, developing potential fear, paralysis or overreaction in investor behavior.
It is therefore important to step back and reflect on how, through history, action has provoked reaction – shocks can lead to offsetting changes to behaviour that undermine the assumptions on which the assessment of the significance of the shock is based.
As such, the dangers of extrapolating the consequences of events can be problematic.
Malthusian trap
Obvious examples abound – not least the Malthusian trap. In 1798, Robert Malthus argued that, as populations can rise exponentially but food supply only linearly, this would drive towards increasing scarcity and a reduction in living standards to the point of mass starvation and population collapse.
The geographical limits to agricultural land was a defining factor in this analysis – and yet advances in technology and science saw such consistent improvements in agricultural yields per unit of land, that food prices have actually fallen in real terms over the long term.
The industrial revolution is often identified as a key enabling factor in that story.
In many ways that revolution was founded on improving technologies for using carbon energy stores (wood, coal, oil) so that “one man with a chainsaw could do the same work as 30 men with axes” – as Jeremy Grantham of GMO recently opined.
But action leads to reaction and, as the mechanisation of the industrial age expanded out through the world, the calls on energy sources expanded to the point where it seemed inconceivable we could continue to satisfy them, leading again to something like a Malthusian trap.
Technological responses
Of course, in retrospect we can see this drove new innovations in insulation, efficiency and renewable energy development … which again affected demand and supply, contributing to lower energy prices, undercutting the competitiveness of renewables and setting back those changes … and so on.
The latest swing-and-consequence has driven an intense focus on global warming – potentially another Malthusian trap pointing towards population catastrophe – and again a significant technological response is underway in the form of the multifaceted sustainability response, which has become mainstream.
We can see the dangers of extrapolation … and yet unforeseen events that drive outcomes that sit outside of what we may think of as a central case can and do happen.
In turn, these may affect the outcomes even of areas we have carefully analysed, leading to cascades of effects outside of the bounds analysis may have suggested.
So views built on a forecast are often highly fragile – thinking instead about an expected range of outcomes is key – but even here we need enough humility to widen the range to account for that deeper uncertainty, which can move events decisively outside of the conceivable.
Moore’s Law
Examples here obviously range among the emergence of global pandemics, scientific discoveries and technological innovations, such as the fantastic progress in the information age founded on microchips and Moore’s Law.
These extraordinary events can have significant effects that reverberate for a long time, which can drive us towards extrapolations if we do not acknowledge the inevitable life cycles of the many similar examples we can observe through history.
Let us look back at a more prosaic, shorter-term recent example. In the course of research Morningstar Investment Management Europe undertook on the ‘FAANGMs’ tech stocks in October 2020, we identified four key risks that were seen by the markets as outliers but which we felt could derail the perpetual growth assumptions championed and embedded in prices:
* Regulation stymying future growth
* The clear shift in consumer preferences through the Covid-19 period proving to be temporary and revert
* The potential for interest rates to rise off of the floor or even for a regime shift
* Finally, historical precedent suggesting a low chance that growth could outpace the rate implied by investor expectations – in short the chance behavioural biases could be clouding investor views.
Three out of four of these have to some extent shown their face – and even the risk from regulation is looking more and more feasible.
In addition, however, the extra inflationary impulse from the war in Ukraine has seen central banks around the world responding by hiking interest rates aggressively – showing that even when the analysis is right, external events can shift the importance and dimensions of these factors in ways that are hard to foresee. That only reinforces the point we made previously about humility.
As we have explored, cause leads to effect and shock to adaptation. As a result, it pays to be sceptical of our ability to forecast and to focus on trying to build analysis – and, ultimately, portfolios – that are robust under a range of outcomes so that, even if we are not all right, we are not all wrong either and thus can stay invested, stay the course and allow history to unfold.
Edward Fane is head of research at Morningstar Investment Management Europe
