What investors can learn from Einstein’s average
Albert Einstein – who knew a thing about numbers, once said, “If you have one hand on a hot plate and one hand in a freezer, on average you will be comfortable.”
That’s why investors need to watch the potentially tranquillising effect the law of averages can have on their investment thinking. To a person who went away last week an examination of Friday night’s markets close may have left them yawning.
Yet the modest gains recorded in most markets masked a major rise in volatility. There were a raft of possible (and interconnected) reasons:
- a slump in China
- continuing falls in commodity markets
- weakness in emerging markets
- global growth disappointments
- the possibility the US would raise rates for the first time in nearly a decade.
On one hand, the freezer
Rather like Einstein’s “average” man, market analysts boil these arguments down to two alternatives; either markets were overvalued and overdue for a correction, or global recessionary risks have increased.
Personally I'm sceptical that the global growth outlook is downshifting and recession risks rising because growth is improving in the US and Europe and to a lesser extent in Japan.
However, this does not mean that all risk is being overpriced and that markets will rise from here. Yes, the advanced economies seem to be improving and this should prevent a sustained bear market. Yet deflationary pressures are also building and this will affect share earnings in a world where valuations aren't low and policy options are limited.
On the other, the hotplate
So while investors may think that future returns are likely to be lower (which they are) they also need to be cautious about painting all asset classes and all regions - and all the sectors within each asset class - with the same low-return brush.
Even if “average returns” were set to be zero (which is not my central scenario), that means half of the market players should outperform and rise.
Where investors should be?
The key at this juncture of the cycle is looking for assets which have reasonable valuations. Equities are a better option than bonds and the key then is identifying countries (and sectors) where earnings per share growth is being upgraded and policy stimulus likely to be maintained.
On those grounds, Japan and Europe are superior to the US, Australia and the emerging markets, large caps are preferred to small caps and the key in those sectors are strong balance sheets and robust operating models.
The more times change, the more they stay the same.