Spend your time on “what is”, not “what if”. I picked up the phrase from The 10 Pillars of Wealth by Alex Becker. It seems apt given many recent discussions on the global economic environment. I am a strong believer in scenario analysis and have talked about scenarios as good tools even for trend-followers to assess potential risks, yet there is a hidden or implicit assumption that is more important for any financial discussion – what is the current environment.
I have found that many cannot agree on what is the current economic environment so any discussion on what the future may hold is likely to be suspect. Answer the simple question first, “Where are we?” before you go onto the next question, “Where are we going?”
Investors diversify simply because they are not sure of three things: what is the economic environment, where it is going, and what is the link between growth and financial asset pricing. Investors would not need diversification if they are certain on these three things.
The first job of investors is not prediction but proper description. A description of the environment is not a data dump of current facts, but simpler. Is the economic environment growing or not? Is it accelerating or is momentum slowing?
Certainly many market analysts spend time telling investors what is the latest news, but that is not the same as defining the current environment. In the simplest case, the environment can be rationalized by a few key states or variables, growth or no growth, increasing or decreasing liquidity, and risk-on or risk-off. Determining the state of the environment is not the same as describing the latest economic data. Data without context does not tell us much. The economic growth state does not change that often so following any day or week surprises will not likely change the economic environment.
Worry about the current economic state of the world and then determine the scenarios that will get you to the next state. Scenarios for tomorrow will be deeply affected by the state of today.
Ride the trend but remember what is possible
Using scenario analysis to help with asset allocation – A simple solution to a complex problem
Scenario Analysis for Systematic Managers? Absolutely!
A simple taxonomy of diversification – All diversifiers are not alike
Accept the investment environment – Just use the right tools to describe it, cases and scenarios