Uncertainty: Love It Or Hate It?

 |  Includes: BND
by: Wade Slome, CFA

Uncertainty is like a fin you see cutting through the water - many people are uncertain whether the fin sticking out of the water is a great white shark or a dolphin. Uncertainty generates fear, and fear often produces paralysis. This financially unproductive phenomenon has also reared its ugly fin in the investment world, which has led to low-yield apathy, and desensitization to both interest rate and inflation risks.

The mass exodus out of stocks into bonds worked well for the very few that timed an early 2008 exit out of equities, but since early 2009, the performance of stocks has handily trounced bonds (the S&P has outperformed the bond market (NYSEARCA:BND) by almost 100% since the beginning of March 2009, if you exclude dividends and interest). While the cozy comfort of bonds has suited investors over the last five years, a rude awakening awaits the bond-heavy masses when the uncertain economic clouds surrounding us eventually lift.

The Certainty of Uncertainty

What do we know about uncertainty? Well for starters, we know that uncertainty cannot be avoided. Or as former Secretary of the Treasury Robert Rubin stated so aptly, "Nothing is certain - except uncertainty."

Why in the world would one of the world's richest and most successful investors like Warren Buffett embrace uncertainty by imploring investors to "buy fear, and sell greed?" How can Buffett's statement be valid when the mantra we continually hear spewed over the airwaves is that "investors hate uncertainty and love clarity?" The short answer is that clarity is costly (i.e., investors are forced to pay a cherry price for certainty). Dean Witter, the founder of his namesake brokerage firm in 1924, addressed the issue of certainty in these shrewd comments he made some 78 years ago, right before the end of worst bear market in history:

Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.

Undoubtedly, some investors hate uncertainty, but I think there needs to be a distinction between good investors and bad investors. Don Hays, the strategist at Hays Advisory, straightforwardly notes, "Good investors love uncertainty."

When everything is clear to everyone, including the novice investing cab driver and hairdresser, like in the late 1990s technology bubble, the actual risk is in fact far greater than the perceived risk. Or as Morgan Housel from Motley Fool sarcastically points out, "Someone remind me when economic uncertainty didn't exist. 2000? 2007?"

What's There to Worry About?

I've heard financial bears argue a lot of things, but I haven't heard any make the case there is little uncertainty currently. I'll let you be the judge by listing these following issues I read and listen to on a daily basis:

  • Fiscal cliff induced recession risks
  • Syria's potential use of chemical weapons
  • Iran's destabilizing nuclear program
  • North Korean missile tests by questionable new regime
  • Potential Greek debt default and exit from the eurozone
  • QE3 (Quantitative Easing) and looming inflation and asset bubble(s)
  • Higher taxes
  • Lower entitlements
  • Fear of the collapse in the U.S. dollar's value
  • Rigged Wall Street game
  • Excessive Dodd-Frank financial regulation
  • Obamacare
  • High Frequency Trading / Flash Crash
  • Unsustainably growing healthcare costs
  • Exploding college tuition rates
  • Global warming and superstorms
  • Etc.
  • Etc.
  • Etc.

I could go on for another page or two, but I think you get the gist. While I freely admit there is much less uncertainty than we experienced in the 2008-2009 timeframe, investors still remain very cautious. The trillions of dollars hemorrhaging out of stocks into bonds helps make my case fairly clear.

As investors plan for a future entitlement-light world, nobody can confidently count on Social Security and Medicare to help fund our umbrella-drink-filled vacations and senior tour golf outings. Today, the risk of parking your life savings in low-rate wealth destroying investment vehicles should be a major concern for all long-term investors. As I continually remind readers, bonds have a place in all portfolios, especially for income dependent retirees. However, any truly diversified portfolio will have exposure to equities, as long as the allocation in the investment plan meshes with the individual's risk tolerance and liquidity needs.

Given all the uncertain floating fins lurking in the economic background, what would I tell investors to do with their hard-earned money? I simply defer to my pal (figuratively speaking) Warren Buffett, who recently said in a Charlie Rose interview, "Overwhelmingly, for people that can invest over time, equities are the best place to put their money." For the vast majority of investors who should have an investment time horizon of more than 10 years, that is a question I can answer with certainty.