Why investors should think the unthinkable
Henning Stein, PhD, GCB.D
Results-Oriented Investment Solutions Executive | Asset & Wealth Management Change Agent
A thought experiment for a world in conflict
In the late 1940s, as mounting East-West tensions cast a shadow over the nascent atomic age, military strategist Bernard Brodie observed: “War is unthinkable but not impossible, and therefore we must think about it.” The events of the past year have shown this dictum still applies.
According to the Bulletin of the Atomic Scientists, the Doomsday Clock stands at 90 seconds to midnight. This is the closest to global catastrophe it has ever been – supposedly signifying that we are living, in the Bulletin’s words, “in a time of unprecedented danger”.
Does this mean investors should also think the unthinkable? I believe we should, although I do not say this because I suspect all-consuming conflict is imminent: there is plenty of evidence to suggest the world has generally become a less belligerent place, and I always cling to the hope that sanity will eventually prevail.
The reason I believe investors should think the unthinkable is simply that doing so, by its very nature, serves as a useful thought experiment. Moreover, in this case it is an experiment that underscores many of the key qualities of long-term investing.
So let us give it a try. I have written on numerous occasions about the value of the bigger picture, and it surely gets no bigger than this. We are about to consider what we might do if the whole world – at least metaphorically speaking – were to go up in flames.
The golden age
By way of context and comparison, we should first reflect on what we might do in less challenging circumstances. What characterizes successful investing in a classic Goldilocks scenario, where the economy is neither too hot nor too cold and low inflation encourages market-friendly monetary policy?
Although it might feel like a distant memory, this is essentially what we experienced for much of the period prior to the multiple crises of recent years. For around four decades, allowing for conspicuous spells of volatility, equities performed well – sometimes spectacularly so – while bonds enjoyed their longest-ever bull run.
Particularly during the 1980s and 1990s, this combination of attractive returns and reliable safe havens regularly lent itself to the classic 60/40 portfolio. Such an approach very often generated equity-like performance without equity-like risk.
Between 1980 and 2022, for example, a 60/40 portfolio invested in the S&P 500 Total Return Index and the Bloomberg US Aggregate Total Return Index delivered positive performance in 35 of 42 years (a). Equities usually did most of the heavy lifting, especially in the wake of the global financial crisis.
It already appears appropriate to wistfully look back on this remarkable era as a golden age of investing. Today, by marked contrast, it is more a matter of searching for silver linings.
The hunt for resilience
Even during the golden age, of course, there were ways of outperforming the 60/40 paradigm. One means of adding luster was to employ a diversified, multi-asset strategy – the likely advantages of which have increasingly been recognized of late.
Issues such as rampant inflation, soaring interest rates and energy shortages conspired to make 2022 a notably grim year for 60/40 portfolios. For a while it was expected to be the worst in a century. In the end, with correlations between bonds and equities turning neutral or even positive, losses averaged around 18% (b).
Needless to say, Russia’s invasion of Ukraine has also played an enormous part in the still-unfolding tumult. Many of us have found out for the first time in our lives how the far-reaching ripple effects of war can reshape investment decisions.
We have discovered, for instance, the true importance of investing with both political risk and security in mind. We have discovered the real significance of global supply chains. We have discovered that sectors frequently viewed with disdain – defense, oil and gas foremost among them – can seldom be dismissed out of hand.
Maybe above all, in seeking assets capable of resilience amid extreme geopolitical and geo-economic uncertainty, many investors have been forced to look further afield. Potentially more resilient investments have included gold, cutting-edge ETFs and energy, healthcare and high-quality tech businesses.
Prospective escalation and realistic frameworks
But where would we look if war were to spread? Where would we look if the prophets of doom are right and the current state of affairs deteriorates? This is where we venture into “unthinkable” territory, which is why it is worth quickly outlining some parameters.
I do not pretend for a moment that there is huge merit in imagining how we might invest in the face of Armageddon. This would take us too far into the realms of speculation and would hardly square with either my enduring faith in humanity or the well-informed, long-term outlook I routinely advocate.
Equally, I do not envisage a dystopian landscape in which the business sphere collapses, equities become a thing of the past and prosperity is therefore defined by, say, how much precious metal or canned food someone manages to hoard. Again, I have somewhat brighter hopes than that.
Ultimately, absolute cataclysm is the stuff of guesswork. But I do believe we can think about the investment implications of a situation more serious than the one that envelops us at present.
To do this, inevitably, we must look to the past and attempt to find possible parallels with the World Wars. Reassuringly, it is here that some familiar investment lessons emerge.
Opportunity and prosperity in the midst of mayhem
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It is no exaggeration to say the outbreak of World War I sparked panic among investors. Liquidity dried up, short-term interest rates went through the roof, and stock markets shut down.
Yet in January 1915, when the New York Stock Exchange reopened, equities in the US – which was neutral at the time – quickly boomed. Broadly speaking, they went on to double in price during the next two years.
The story in Europe was obviously less appealing. In Britain, for example, stocks lost value throughout the conflict. Nonetheless, the fact remains that there were still opportunities to be found – even in the midst of “the war to end all wars”.
Perhaps in light of the experience of 1914, investor reaction to the start of World War II was less pronounced. Markets actually went up when Nazi forces entered Poland; they fell slightly after the Japanese attack on Pearl Harbor, but these losses were recovered in less than a month.
Overall, the Dow Jones recorded a rise of around 50% between 1939 and Germany’s surrender in 1945. It may seem crass to say as much, but glance at the full sweep of the log-scale history of the S&P 500 today and you might struggle to discern when World War II took place.
Keep calm and carry on
The above summary is unquestionably simplified and selective. Even so, it highlights two points that are still germane today and which could become even more relevant in the future.
The first is that markets tend to overreact to war and then revert to relative calm. We have already witnessed this phenomenon in response to the invasion of Ukraine: the S&P 500 fell by more than 7% in the immediate aftermath of the incursion, but it was trading at a higher level than previously within a month.
The second is that conflict-related volatility invariably creates dislocations, which in turn create opportunities for long-term investors who appreciate the bigger picture. While it might be in some ways uncomfortable, this truth has also played out over the past year.
Crucially, taken together, these realities demonstrate a further vital lesson for long-term investors. It is this: dramatic geopolitical and geo-economic developments might require us to reassess our asset allocations, but they rarely – if ever – require us to abandon our underpinning philosophy.
All being well, the world will not go up in flames – either metaphorically or, heaven forbid, literally – anytime soon. But in confronting this putatively unthinkable prospect, however briefly, we can at least remind ourselves that there is a massive difference – even in extremis – between prudently rebalancing a portfolio and completely losing sight of its raison d’être.
Disclaimer: The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks.
References
Fred Kaplan: “The Wizards of Armageddon”
The Bulletin of the Atomic Scientists: “A time of unprecedented danger: it is 90 seconds to midnight”
University of York: “Study settles the score on whether the modern world is less violent”
Reuters: “60/40 portfolios are facing worst returns in 100 years: BofA”
Tradingview.com: “S&P 500 Index – historical chart (log scale)”
a JP Morgan: “Is the 60/40 dead?”, 2023
b Goldman Sachs: “Is the 60/40 dead?”, 2022
Very insightful historical parallels on market behaviour in the light of geopolitical risk shocks! Thank you for sharing it, Henning Stein, PhD, GCB.D