Something that has been talked about repeatedly during the Covid-19 crisis is just how much we don't know. It has been a lesson in how limited our foresight can be.
At first, we did not know how far or how quickly the virus might spread. Neither did we know how severe it may turn out to be.
Once governments started imposing lockdown restrictions, we did not how long these might last, or how they would be lifted. We couldn't be sure how many jobs would be lost, or how household incomes would be impacted.
The economic impact remains a point of extensive debate. How deep will the recession be? And how long will it last? Could economies still bounce back as quickly as we originally hoped they would?
As countries ease lockdown restrictions, how many people will be able to return to the jobs they had before Covid-19? Which sectors will return to productivity quickly, and which will continue to struggle?
Over the longer term, what are the lasting effects of the pandemic likely to be? Will airlines and cruise ship operators ever recover fully? Will restaurants have to come up with new operating models?
What will be the impact on global supply chains? Is this likely to be the start of a significant shift away from Chinese production? Will companies look to diversify where they source components?
How significantly will the pandemic and its fall-out disrupt global politics? Will it spur on nationalist movements and reduce multinational cooperation? Could it lead to a cold war, or even a full military conflict, between the US and China?
These are all scenarios with meaningful implications for financial markets. Asset prices could react in vastly different ways depending on how events play out.
How then should investors prepare?
It might be reasonable to believe that in order to be successful you have to be able to predict what is going to happen. Or at the very least, you have to get more predictions right than wrong.
This is what some fund managers will try to do. They will position their portfolios based on how they believe things will play out.
Some of the time, some of them are certain to be right. They will look extremely clever in those moments as they could earn large amounts of outperformance.
However, there are so many variables, that it is extremely unlikely that any manager attempting this strategy will anticipate everything correctly. Some of these successes are therefore likely to be extremely transitory.
Getting the odds in your favour
Given how poor we are at predicting the future, a more sustainable approach is not to try to 'call' events correctly. It is rather to think in terms of how much you can prepare for.
During a discussion at the 2020 CFA Institute annual virtual conference, the Collaborative Fund's Morgan Housel made the comment that "being successful is not about being right as often as you can. It's about surviving the broadest possible range of outcomes.”
For active managers this means constructing diversified portfolios that don't depend on a particular event or set of outcomes. They need to balance their risks.
It is, however, worth considering what kind of portfolio would capture the broadest range of scenarios. Logically, that has to be the entire market.
The index advantage
The only way to capture every possibility is to hold everything. Of course it's true that this isn't wholly efficient. That is why there will always be some active managers that outperform the market some of the time.
However, over the long term, it is the only strategy that an investor can be certain will met Housel's requirement of “surviving the broadest possible range of outcomes”. That is, after all, what the market is — the reflection of the cumulative impact of everything on asset prices.