How Smart Investors Can Profit from Uncertain Environments

Nov 14, 2012
Those who have left the market because of macro uncertainty are missing out, says Sanibel Captiva's Pat Dorsey.
 

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Markets may not like bad news, but they really hate uncertainty, and unfortunately there's no shortage of that in the market today. Morningstar.com’s site editor Jason Stipp spoke with Pat Dorsey, president of Sanibel Captiva Investment Advisers, to get advice on how to think while investing in such an uncertain market environment.

I don't even need to look down at the list, we see them in the headlines all the time: the European situation, the fiscal cliff, China's economy and the hard or the soft landing. There's really no shortage of things that could happen one way or the other, and investors are wondering what the outcomes are going to be. When you think about such an uncertain environment as an investor, you're tempted to take action and try to do something. But what should investors really sit back and think about, when they're faced with a situation where we really just don't know the outcome yet?

I think the first thing to ask yourself is how will this actually affect my portfolio? Because frankly, Greece leaving the euro, if you have a portfolio of small Greek retailers, you should be very frightened. If you have a portfolio of largely multinational large caps it's just not going to be that big a deal. It causes a lot of headlines, but it's probably not going to affect your financial life all that much. So, I think that's the first question is how could this actually affect my life, my portfolio? Not the market.

I think one of the things investors worry about as well are valuations. So, when you do have uncertainty, you say that maybe it's not all a bad thing, even though it causes us to wring our hands, in fact when you're wringing your hands, maybe that's the time that you see some bargains in the market.

Yes, I actually think that's one of the biggest investment positives right now, is the amount of uncertainty and worry that's out there. Because dangerous times to invest is when everybody is certain, when everybody is confident about the future. When they're positive that Yahoo! will go to $1,000 a share in 1999, when they're positive that the U.S. home values can never go down, as they were in 2007.

So, it's when you have that kind of confidence that gets extrapolated out into very high valuations, that's when you get a risky investing environment. Whereas amid uncertainty when people are unsure, they are willing to place a discount on assets, well that's when I think investing actually is safer.

So, let me ask you the question though, there is uncertainty, in order to feel like you can go out and invest in such a market where you might find bargains, do you feel like you have to know the answer? Is it important for you as an investor to say, "I believe that China will have a soft landing and so I'm going to invest because of that and if I don't, I won't invest"? Or is there some middle ground there where you can admit to yourself that you don't know, but you still manage to invest?

I think there's probably sort of a Zen Koan in here right, like the first step to knowing is not knowing or something, along those lines. But I think it's very true that people like easy answers. They like to follow the guy who says, "China will have a hard landing. I am confident in this and you should invest your assets in such and such a way."

But the reality is that those kinds of macro predictions have very poor track records of actually coming to pass correctly, and so, I think as an investor you always want to have an opinion. You want to have something that drives how you think about the world, how you structure your portfolio. And you want to change that opinion as new data becomes available, so you're not dogmatically wedded to one point of view. But trying to think that you must know the future with absolute certainty before taking an investment action, I think you'd be sitting in cash a long time.

What are some ways to hedge some of these bets, knowing that you're not going to know for sure even if you have an opinion? And you mentioned one thing, if you're overly concentrated in an area that could be exposed to a negative outcome, even if you don't believe that it'll happen, is one where you obviously take on probably more risk than you want.

So, on the flip side, how do you hedge some of that risk and say, maybe there's a 60% chance this will happen, but I also want to invest for that 40% chance that it will go the other way. What do you do? What kinds of companies, what kinds of allocations do you look for?

I mean of course it completely depends on what you're trying to hedge against. But I think that one of the key questions to ask yourself is something not many people do, which is how much is this hedge costing me? People will often think about hedging as like this is sort of panacea to all things, but hedging is just like insurance, right. If someone came to you with two fire insurance policies that both covered your house for $200,000 but one costs $6,000 a year and one costs $2,000, you'd buy the one that costs $2,000 because it's offering you the same protection, and I think that's the same way to think about hedging, using out-of-the-money puts or things like this.

It can work if you're a very savvy investor, but I think one of the easiest ways to hedge if you happen to be nervous about the world, just hold a little more cash. Maybe your typical cash holding is 5%, up it to 10%. Is it going to kill you?

The key though is that when you see investors a lot of times who raise a lot of cash going into an uncertain environment, they don't get back in if the environment turns out to be rosier than they had expected. And so I think that's why it's important to actually physically write down, "What data points am I looking for? What events do I think might come to pass? And if they don't, when would I take at least some of this cash and recommit it to the market?" Because as I find, the biggest risk for the investor who sort of pulls back out of fear or worry is that they don't get back in because they never thought about when would they.

My last question for you. When we do have some of these events, and we'll have resolution to them at some point in the next six months or so, how do markets tend to react when they get the answer and they sort of think they know what's going to happen because we got this answer about the election or we got this answer about what's going to happen with Greece--I'm not suggesting that will happen in six months, but there's more certainty that starts to come along with this process. Do you have to think differently as an investor when the environment shifts and you start to get some of these answers?

No, I think what you often find is that there's basically sort of an anticlimactic reaction. This is the old sort of "buy the rumor, sell the news" saying in the market where things get pretty well discounted in market prices. And so when you get the eventual piece of news you've been waiting for--what will the election results be, how will the fiscal cliff be resolved, does Greece stay in the euro or whatever it might be--I think you tend to see a very anticlimactic reaction in the market. And that's why I think it's important as an investor to remain flexible and not be dogmatically wedded to a certain viewpoint. Take the data in as they come, and if you need to adjust your opinion from that 60%-40% outcome you mentioned earlier to a 40%-60% outcome, do so and position your portfolio appropriately.

So, bottom line, uncertainty is certainly not a reason that you have to completely on the sidelines and in fact it could be a reason that you'd want to be in the game?

It's probably one of the biggest positives for an investor right now.

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