The Uncertainty Paradox

The stock market hates uncertainty.

Sure, that's a common enough saying these days, but how logical is it?

There are many different types of uncertainty, some that can easily be quantified and others that cannot. Uncertainty is an immutable condition of existence. As individual investors, we can feel more certain or less certain, but the fact is that it is a decidedly human phenomenon.

Rather than ebbing and flowing with investor sentiment, uncertainty remains an intrinsic and ever-present aspect of investing. Any investment that has a potential return greater than the prevailing risk-free rate (think Gilts in the UK or Treasuries in the US) involves a tradeoff between certainty and potential reward.

Think of this concept through the lens of stock vs. bond investments.

Stocks have a higher expected return than bonds because stock investors have more uncertainty about the future state of the world than bond investors.

Bonds generally have fixed coupon payments and a maturity date when the principal is expected to be repaid. Stocks have neither.

Bonds also sit higher in a company's capital structure. When a company goes bankrupt, bondholders are paid before stockholders.

So, do investors avoid stocks in favour of bonds as a result of this increased uncertainty?

Quite the contrary, many investors end up allocating capital to stocks because of their higher expected returns. In the end, many investors are often willing to trade off some additional uncertainty for potentially higher returns.

Managing Emotions

While the statement "the stock market hates uncertainty" may not be entirely logical, that doesn't mean it lacks educational value.

Indeed, thinking about what this statement says allows us to gain insight into the mindset of the typical individual investors.

The statement seeks to personify the stock market by citing the very real jitters and fears that some investors feel as volatility increases.

This is in recognition of the fact that as stock markets go up and down, many investors struggle to separate their emotions from their investments.

Ultimately, this tells us that for most investors, regardless of whether stock markets have made new highs or are falling, changes in stock prices can be a source of concern.

During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight do we feel as if we know whether any time period was a good one to be invested.

Unfortunately, while the past may be a precedent, the future remains uncertain.

Staying in Your Seat

Prospective clients often ask me the question:

"How long do I have to wait for an investment strategy to pay off?

And my answer is it’s at least one year longer than you’re willing to give.

There is no magic number. Risk is always there.

Part of being able to stay unemotional in times of heightened uncertainty is having an appropriate asset allocation that is consistent with an investor's willingness and ability to bear risk.

It also helps to remember that, during what feels like good times and bad, one wouldn’t expect to earn a higher return without taking on some form of risk.

While falling stock markets may not feel good, having an investment portfolio that you are comfortable with, understanding that uncertainty is part of investing, and sticking to a pre-agreed and regularly revised financial plan can help prevent investors from reacting emotionally.

This ultimately leads to a better investment experience.

Amyr Rocha Lima, CFP® is a financial planner who specialises in working with successful professionals age 50+ to help them reduce taxes, invest smarter and retire on their terms.

”Amyr has provided me with objective and impartial advice when reviewing my financial plan and objectives. Amyr has excellent technical knowledge and, more importantly, he delivers his advice clearly and in a way that helps you decide your next steps."

Paul Dawson
(Senior Risk and Compliance Officer - Metlife)

*****

”I appreciated Amyr's friendly, relaxed and helpful manner and, even more, his highly professional approach. He soon understood my financial situation and what I was looking for. The financial plan he proposed met my requirements. I have every confidence we will have a good working relationship in the years ahead.”

Louise Anstead
(London Stock Exchange)

*****

”After trying several IFAs who did not 'cut the mustard' I was lucky enough to find Amyr. He has been exemplary in his dealings with me. He is very professional, knowledgeable, honest, friendly, and (most important to me) someone I know that I can trust with my financial affairs.”

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(Certification Specialist - Civil Aviation Authority)

*****

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