May 18, 2012: The Importance of Uncertainty

One must understand the philosophical underpinnings of the Permanent Portfolio before the asset allocation begins to make sense.

Many investors first attempt to predict a future scenario in financial markets, and then position themselves to profit from their prediction. The Permanent Portfolio uses an opposite logic. Harry Browne assumed that the future direction of asset classes was unpredictable, so he attempted to find a portfolio that would allow for profits no matter what happened in the broader economy. To internalize this philosophy, one must cast aside any fantasies about predicting financial markets directions. Investment finance is a field dominated by big egos, so the humility required to acknowledge unpredictability is less common than one might think.

Ironically, by acknowledging uncertainty you can be more certain about your future returns. Why? Because you are prepared for events that are beyond imagination, like the Japanese earthquakes. Even the most sophisticated economic model could not have accounted for the massive earthquakes. The biggest drivers of returns in financial markets come as complete surprise to most investors, and for many of them luck is an important but under-recognized component of their returns.

The only way to circumvent the element of chance is to have broad diversification in place at all times, and this level of diversification requires discipline and humility. You can’t wait for signs of weakness in any asset class, because by then it is usually too late. This works in exactly the same way for rising markets. I was shocked to see the market rally off of the bottom of the financial crises. Everything seemed so terrible. How could stocks rally when the world was seemingly falling apart? If I had waited for signs of recovery I could have missed big gains. Predictions about individual asset classes would have left me with a less predictable portfolio!

Harry Browne encapsulated this philosophy by simply acknowledging “the best kept secret in the investing world: Almost nothing turns out as expected.” To me, that should be the philosophical foundation for portfolio management. Even if the PP is not for you, perhaps because the individual components are too difficult to stomach, I hope that the foundation can inspire you to embrace uncertainty and ultimately profit from it.

No comments:

Post a Comment