The biggest risk is always something which we are not aware of yet.
In 1941 the Japanese army surprisingly attacked the American fleet stationed in Pearl Harbor causing vast casualties and damages. Despite the fact that Japanese forces didn’t have an advantage in numbers and were far away from their bases their victory was unquestionable.
6 months later the Japanese tried to repeat their tactics when they attacked Midway – another key American base in the Pacific Ocean. This time, however, the Americans not only managed to defend the island but they inflicted devastating damage on the Japanese fleet. Military historian John Keegan called it “the most stunning and decisive blow in the history of naval warfare”.
In both battles the forces on each side were comparable. Yet, in Pearl Harbour, the Americans were completely surprised, whereas with Midway American cryptographers discovered Japanese plans and the American fleet got prepared. By the time the Japanese planes attacked Midway, they were ready to fight back.
The biggest risks are those that we don’t know about. This is true in war as well as in the financial markets.
The risks that are talked about and are well flagged are rarely leading to major events in the markets. There are two simple reasons for that.
If everybody is talking about it, investors have time to prepare for that risk materializing.
It is best explained when looking at political elections and their market impact. Every change in government brings uncertainty, especially if the incoming administration is coming to power with a populist agenda. That is why election cycles, especially in emerging markets, are always event risks. However, if you study the price behaviours you would see an interesting pattern. Whenever there are elections when one candidate (or one party) is regarded as a threat to economic stability the markets usually begin to price the risky outcome well ahead. Then, very often around the election date, the markets start to rally regardless of the election outcome. It was the case when populist AMLO came to power in Mexico (2018) or Bolsonaro in Brazil (2018). The same happened in developed markets with populists forming the government in Italy (2018) or the elections in the UK (December 2019).
The other reason why the risks we know about do not cause major sell-offs is often because they simply do not happen.
When everybody talks about the risk its probability of occurring decreases.
Let’s take a recent example from the US repo market (the most liquid market in the world) from the end of 2019. After the market unexpectedly blew up in September 2019, the Federal Reserve implemented measures so that it wouldn’t happen again. Despite that many investors were convinced that another crash in the market by the end of the year was inevitable (https://www.zerohedge.com/markets/its-about-get-very-bad-repo-market-legend-predicts-market-crash-days).
And guess what? Nothing happened. The Fed and major US banks got so scared of the end-of-year lack of liquidity that they built enough buffers to avoid disruptions.
Other examples include the key geopolitical risks of 2019: US-China trade war, the risk of European populism, hard Brexit… None of those caused major shocks to the markets in 2019 (yet it did cause a lot of noise and some price volatility).
So what kind of risks have caused major turbulence in the markets?
The September 11 terrorist attacks, the collapse of Lehman Brothers, or the Brexit referendum. There is one common feature across those events – they were all unexpected. And because investors were not prepared they caused massive volatility in the aftermath.
Now, with that in mind let’s look at what are the major key risks that analysts see for 2020. The Impeachment process in the US, presidential elections in the US and once again the ongoing US-China trade tensions. I obviously do not know what is going to happen but I would be surprised if any of those caused the markets to blow up this year.
If the most dangerous are those risks we don’t know about, what can we do about it when investing?
Don’t pay too much attention to analysts’ returns forecasts.
All forecasts are created based on today’s pricing and currently available information. For obvious reasons they can’t factor what we don’t know.
Think of the worst-case scenario despite not knowing when and how it will happen.
The fact that you don’t know what will cause nor when will be a major risk event does not mean you should not prepare yourself. Of course, you can’t hedge against the unknown but you can ask yourself: if a major market crash happens today, would my portfolio survive such a shock?
Don’t worry too much about the “known” event risk.
I’m not suggesting you should not prepare yourself for it. But as I explained – the more people talk about something the less likely it will have a meaningful impact.
Be wary if there are no risk scenarios.
Whenever forecasters begin to picture a future only in bright colours this is the time to remain extra vigilant.
Pricing risk is a very complex and a difficult thing to do. What makes it even worse is that the biggest threat is always something we are not aware of. Yet, we should always try to be prepared for it.