How should policy makers (which of course includes investors) respond to uncertainty? I ask because there seems to be a paradox here.
On the one hand, uncertainty is a reason for the Bank of England to do nothing. Holger Schmieding at Berenberg Bank says the emergence of the Omicron variant of the coronavirus “may strengthen the case for caution” in raising rates. This reflects something proposed by Yale University’s William Brainard in 1967 – that, faced with uncertainty, policy-makers should err on the side of doing nothing. Alan Blinder, a former vice-chairman of the Fed, has said that this idea “was never far from my mind” while he was setting interest rates.
For company bosses too, uncertainty is a reason to do less. Stanford University’s Nick Bloom has shown that it tends to reduce business investment.
On the other hand, though, uncertainty is sometimes a reason for acting swiftly and severely. One criticism of the government is that it failed to impose a sufficiently harsh lockdown quickly enough when Covid-19 first emerged last year.
But how can uncertainty be both a case for doing nothing and also for taking fast and drastic action?
Simple. Policy-makers must act upon the distribution of possible outcomes. Uncertainty about a pandemic encompasses some truly horrible possibilities such as mass deaths. Preventing these required draconian actions.
In such circumstances, what matters is tail risk, the (perhaps unquantifiable) chance of catastrophe. If you’re flying a plane or running a nuclear power station, focusing upon this is paramount. This is also why it’s not good enough for police chiefs to talk about a few “bad apples”: the damage done by one or two rogue officers is so great that their bosses must guard against it.
In other circumstances, though, it makes sense to focus on the other end of the distribution – the small chance of good big pay-offs if the downside to doing so is small. In his recent book Tarzan Economics, Will Page points out that Sweden produces lots of entrepreneurs. One reason for this is that its employment laws allow people to take sabbaticals in which they can try to set up their own businesses but return to their jobs if they fail. Little downside plus nice upside encourages entrepreneurship.
For central banks now, however, uncertainty is more symmetric. Yes, there’s a risk of sustained inflation, but there are also risks of economic activity faltering. Faced with this sort of uncertainty, doing nothing until the fog lifts makes sense.
I say all this because it’s that time of year when journalists and finance professionals give their forecasts for the year. Such forecasts are close to useless unless they are either testing clear hypotheses or come with a margin of error, because no sensible person should ever act upon a point forecast: it’s the distribution that matters.
Almost all of you actually already act upon this. Most point forecasts are for equities to outperform cash or bonds in 2022. (This isn’t because forecasters know anything; it’s just because there’s a risk premium in equities.) But almost none of us has everything in equities and nothing in cash or bonds. That’s because you invest on the basis of the distribution of possible returns, not single forecasts of them – and such distributions encompass a good chance of shares underperforming bonds.
We should not try to foresee the future, but instead ensure that our portfolios (and indeed our lives in general) are resilient to whatever surprises 2022 throws at us.