Good or Bad?

Posted by on 07/22/09 in Behavior, Markets

There is an old tale about the wise farmer who has learned that it is difficult to know whether news is good or bad, seeing as the results of seemingly good news can be horrendous, just as seemingly bad news can bring good fortune. In the tale, his son falls from a horse and breaks his leg. The neighbors are lamenting the farmer’s bad luck, when the king’s forces arrive to forcibly conscript all of the able-bodied young men. The farmer’s son is saved because of the very broken leg that seemed so tragic just a few hours before. Was it good or was it bad to break that leg?

So arrive at one of the interesting challenges of predicting the markets. As of market close on Tuesday, the S&P 500 hit 954 points. Is that good or is that bad?

Some may see the achievement as a harbinger (no hedge fund puns intended) of more near-term increases in equity prices. Indeed, strategists at five major banks expect the S&P 500 to hit in the 1000-1100 range by year-end 2009. Concurrently, however, 954 is well above the year end price targets for strategists at five other major banks. In short, predicting even the most efficient and transparent of the securities markets (large cap US equity) is at best a terribly difficult endeavor.

So, if we have learned anything from 2007-2009, it is that one must build an investment strategy that considers multiple possibilities. Rather than focusing on “most likely” or “mean” scenarios as the industry tends to do, portfolio strategists must focus on many contingencies, including most significantly those on the potential extremes. Thus, a single portfolio must reflect the risk management strategy of many scenarios.

Unfortunately, this need to plan for multiple ends conflicts with most investors’ desire for certainty. How can you feel good about your strategy (or your Adviser) when they cannot tell you with high confidence what will be happening in the markets? Alas—and ironically—our psychological desire for predictability conflicts with our psychological need to protect ourselves from uncertainty. After all, we cannot truly protect ourselves by creating a false sense of security, no matter how good that would feel.