Article by Somnath Banerjee
I don’t want to turn this into a geeky piece but then I do have to talk about some math here. I will keep it to the level where you may not feel a drive through colonoscopy but just a little headache after a small overdose of alcoholic beverage after a night out.
Let me get the nerdy stuff out of the way now so that you can be pleasured reading the rest (I have to assume that). ‘Weighted Average’ is a weighted total of a set of numbers divided by the total of those numbers.
Assume you can invest €100 in an investment opportunity, and that there are three possible outcomes:
- A with a probability of 10% and a return of €5;
- B with a probability of 60% and a return of €105; and
- C with a probability of 30% and a return of €200.
Any seasoned investor would do that trade any day of the week and twice over the weekend, because it has a +23.5% expected return and that will be the actual return if there are ‘many’ investable opportunities like this (we have covered this in one of my previous articles “Hope is a risky strategy.”)
Apart from the little issue that one may not be presented with ‘many’ opportunities which turns the expected return into an “assured return” (I covered this aspect in that op-ed) there is another issue with the expected return calculation.
When it comes to the high world of finance and economics much rides on who is making predictions and the motives behind them. Now, if you are a strategist/economist working for a large institution, one style of working would be to go with consensus and make predictions which are more or less in line with market’s base case scenario. This is called hedging your risk (if things don’t turn out as you predicted you would be like ‘look, I am not the only one who misread the markets’, ‘the whole market believed it’, ‘it was the right thing to assume given market conditions at the time’ etc. etc.)
The second approach is not for the faint hearted. Here you make outrageous predictions (going dramatically opposing consensus expectations) and assign it a ‘low’ probability. ‘Yes, equity markets will double this year with a probability of 20%.’ The upside here is when, once in a while your lady luck smiles upon you (another proof that dudes are never lucky), that will make your career. Big bonuses, luxury yachts, jet liners etc. The downside is if you can’t fake it well enough you may eventually lose your job.
My point is, it is quite possible that tail events may be overweight because of ‘bonus’ bias amongst the ‘knowledgeable’ economists/strategists. Most of the time, markets see through these outrageous predictions and adjusts expected returns accordingly.
However, once in a while, some of these predictions are slow to be adjusted in the expected return and the process of adjustment for markets gets noisy.
Markets have been predicting a terminal rate of c.5% since late 2022, followed by cuts worth c.50bp by the end of 2023, by Federal Reserve in the USA (their Central Bank). It has been justified by bond markets on the premise that the US economy would be in such a bad shape that inflation would come down quicker than the Fed expects and/or financial conditions would tighten so much that the Fed would have to reverse course unexpectedly.
Who knows (least of all, yours truly), it may still happen and we may see rate cuts by the end of the year. However, lately markets have revised their views with current expectation being terminal rates c.5.40% and no cuts this year.
Was this a case of some overzealous bond market participants calling for dooms day and assigning it a larger weight than merited? Only time will tell. But in the mean-time, there is some real pain inflicted by government bond yields rising ‘significantly’ on the back of revised expectations.
So, when you are investing based on expected cash flows and their probabilities, pay extra attention to tail events (on both sides).
Disclaimer
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.