PI Partnership
Of course, this has always been the case, but we believe it will be even more so over the next 20 to 30 years. In a research report we published in 2021², we argued that a series of sustainability issues had reach a stage whereby they would have significant impact on investment returns and should not be ignored. This is particularly because they are themselves the source of increas- ing uncertainty. Sustainability issues such as climate change are not cyclical, they are directional; they take us somewhere new, where historical relationships are less useful or even downright misleading. Thinking with a sustainability mindset is also helpful in encour- aging us to think about economies and financial markets as dynamic systems that evolve and change through time, with few, if any fixed constants. Too much of today’s investment risk man- agement takes simplifying theorems and then defines them as laws and applies fixed constants for means, standard deviations and correlations, etc. Thinking in systems, by contrast, acknowl- edges not just that the parameters are constantly changing but also that there can be positive and negative feedback loops, which create big oscillations and tipping points. The big and sudden events that drive markets are often not so much black swans as the results of slowly accumulating pressure and con- verging trends. Like the moment thousands of tonnes of ice breaks from a glacier and falls into the sea.
While climate change is the elephant in the room of sustainabil- ity issues it is only one potential source of future instability. The world economic system has become increasingly fragile – wit- ness the continuous expansion of debt as well as central bank support for/manipulation of asset prices – and carbon emis- sions are not the only trend which cannot be extrapolated with- out crisis. An economic model that requires ever increasing ine- quality and a smaller and smaller group of companies making larger and larger profits (in absolute terms and vs GDP) is simi- larly not something that can be rationally extrapolated; it is almost mathematically unsustainable. So, a prudent investor might anticipate a period of turbulence in coming years, where historical data-driven risk models prove increasingly vulnerable to radical uncertainty.
So what to do about this? Firstly, avoid thinking about risk in too short a term, statistical, sense. If an investment manager comes to you promising to ‘maximise your risk-adjusted return’ ask them what risk? (What they are really promising is to maximise returns under one spe- cific set of circumstances.) Instead, think of risk as being what threatens your overarching goals – staying in business, having cash to spend, avoiding permanent losses. You can only maximise returns if you are confident in your model of the future. We have sought to argue that such confi- dence is unwise. Evolution favours those who survive, so a port-
folio that is robust and resilient is preferred over one that tries to maximise or is suited to only one environment. That is the per- ennial argument for diversification – ordinary enough – but it is worth reconsidering in what way your portfolio is truly diversified. Complex investment strategies are often (though not always) dependent on models and assumptions that may prove casual- ties of uncertainty. Applying leverage to them only amplifies this risk, in fact significant leverage applied to almost anything reduces its resilience to the unexpected and the ability to hold on. A curious exception seems to be trend following quantitative strategies which often seem to deliver outsized returns in peri- ods of turbulence – perhaps because they are constantly adapt- ing rather than anchored to a prior set of beliefs. At a more granular level, we believe sustainability factors men- tioned earlier can be an important tool to reduce lurking risks that have no obvious timing or quantification. Analysing busi- nesses through a sustainability lens brings important funda- mental information. Costs imposed on society by anti-social businesses – such as pollution, congestion, exploitation of the vulnerable – are often termed externalities or side-effects in that they do not form part of the economic model of the industry. But as John Sterman, director of the MIT systems dynamics group tells us, “there are no side-effects, only effects” and they can come home to roost with unpredictable timing and severity. Finally, remember that uncertainty has upsides; how can inves- tors be best positioned to benefit as the uncertain future unfolds? Venture capital, properly handled, can offer a diversified invest- ment in the future. Most new ideas fail but those that don’t can offer spectacular gains, sometimes at the expense of established businesses that may already be in your portfolio. Seeing the economy as a dynamic system rather than a fixed mechanism is fundamental to this view of managing uncertainty so it is appropriate to finish with a quotation from ³Donella Meadows, environmental scientist and early systems thinker: “Let’s face it, the universe is messy. It is non-linear, turbulent and chaotic. It is dynamic. It spends its time in transient behaviour on its way to somewhere else, not in mathematically neat equilibria. It self-organises and evolves. It creates diversity not uniformity. That’s what makes the world interesting, that’s what makes it beautiful and that’s what makes it work.”
1) Radical Uncertainty, Decision-making beyond the numbers, by John Kay and Mervyn King 2) The Materiality of Sustainability, Cambridge Associates 3) Thinking in Systems: A Primer, 2008
Dec-Jan 2022 portfolio institutional roundtable: Build Back Better
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