An interesting aspect of investment uncertainty is that, contrary to popular belief, it doesn’t reduce as the time horizon lengthens. It’s often pointed out that the longer you hold an equity investment the more likely it is to outperform one in bonds or cash.
This is true because for longer periods the range of possible returns narrows and gravitates towards the long-term average, which is higher for shares than other investments.
But this doesn’t mean that there is more certainty about the number that really matters to an investor, how much their portfolio will be worth at a given point in the future. The reason for this is compound interest. Even a relatively minor difference in return year by year can add up to a yawning gap between best and worst-case outcomes over, say, 15 or 20 years.
Faced with this uncertainty, the natural reaction is to try to gather more information to improve the odds of making a better forecast. Again, this is a fool’s errand because access to lots of facts and figures simply makes us more confident without actually delivering an improvement in accuracy.
Professionals, who are sniffy about the rules of thumb that lay investors rely on and who are confident that they alone understand the maths, are particularly prone to this.
Looping back to where we started, with a hugely uncertain development in the still unfolding pandemic, how should investors really be responding this week? I’d say humility and healthy scepticism would be a good starting point. If we focus on what we know rather than what we hope or think we are more likely to make sensible judgments.
We know that vaccines were developed rapidly that reduced transmission, infection, hospitalisation and death from the original virus and its early mutations. I suspect that science will prevail again in due course. We know that an initial economic hit was quickly reversed. We know that the pandemic creates both winners and losers. And we know that monetary and fiscal policy is responsive to changes in the Covid situation.
This means that last week’s drop was most likely an overreaction but that markets will be more volatile for the foreseeable future. Investors initially assumed the worst. They should also hope for the best. And they should position themselves for the likelihood that we end up somewhere in the middle.
Tom Stevenson is an investment director at Fidelity International. These views are his own. He tweets at @tomstevenson63