There is a well-known idiom that states: “better the devil you know than the devil you don’t.” In investing, this expression applies to the idea that it is often the risks we are least aware of that significantly dislodge markets while those risks that have long been in the headlines tend to be priced in. This framework is an apt one given some of the events we’ve recently experienced.
Greece is like the “devil we know.” It has been in and out of headlines for the last five years. This small country on the periphery of Europe returned to the spotlight this year when conversations with creditors broke down and the possibility of default and an exit from the Eurozone emerged anew. Yet these headlines never resulted in the kind of big shifts in market sentiment that one might expect for all the airtime they received. While events in Greece initially caused a disruption to markets in 2010, Greece has now become the devil we know: markets have had five years to digest this risk.
Greece is like the “devil we know.” It has been in and out of headlines for the last five years.
Compare this to the knee-jerk reaction we saw with China this summer. Although signs of China’s economic struggles were visible well over a year ago (or before), the deterioration of China’s economy barely registered in the minds of western investors early in the year; the world was much more fixated on Europe and the Federal Reserve. Indeed, few noted China’s incredible stock market rally when it occurred and many investors simply shrugged off the growing body of weak economic data as it emerged. It wasn’t until mid-summer when the Chinese devalued the Yuan that China moved decidedly into the spotlight. But when it did, volatility spiked, stock markets retreated and investor unease grew. China was the devil we didn’t know.
First and foremost, we need strategies that can be successful regardless of the scenarios that unfold.
This idea matters for three reasons. First, just because you aren’t aware of a risk does not mean it doesn’t exist. China’s financial system has been a risk for some time now, whether or not it was acknowledged. Second, it can take time for markets to fully digest a risk when it emerges. It took a long time for investors to fully appreciate the risks in the U.S. subprime market after signs emerged in 2005/2006, just as it will probably take some time for investors to understand what’s going on in China. Third, once a risk has been well telegraphed, new “news” may capture headlines but have little influence on asset prices.
While it is important for investors to understand the risks in the investment landscape and how they might already be reflected in asset prices, it is critical to understanding that no one will ever know all of the “devils” that are out there. First and foremost, we need strategies that can be successful regardless of the scenarios that unfold. A systematic, disciplined, and common sense investment approach can help investors build portfolios to be resilient no matter what devils we encounter.