Here are two amusing examples where linear thinking can eventually result in disastrous financial results. I think they directly apply to the world of stock markets, illustrating rapid, or non-linear, change that comes to the detriment of the investor.
If you put a frog into a pot of boiling water, according to one parable, it will immediately sense the extreme change in temperature and will respond by jumping out of the pot. However, if you put the frog into a pot of lukewarm water and turn on the stove so that the water temperature rises slowly to the boiling point, the poor amphibian will not perceive the change and imminent danger.
Outcome? A boiled, very dead frog. (I can't testify to the outcome having never tried this experiment myself.)
Then there is the story told by Nassim Nicholas Taleb in his now famous book, The Black Swan: The Impact of the Highly Improbable. "Consider a turkey that is fed every day," Mr. Taleb writes. "Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race looking out for its best interests, as a politician would say.
"On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief."
In the first example, the subject never realizes the approaching danger, while the second victim has a sudden, dramatic change of perception that comes too late. In both instances, for the frog and the turkey, it results in the same tragic outcome.
So what do these metaphors have to do with investors? A great deal, I believe.
Clients are calm right now. They are reasonably satisfied. There is no panic or threatening events – if you ignore North Korea. The markets, including index funds and ETFs into which trillions of dollars have been poured over the past several years, have returned good numbers – better than average actively managed funds as a whole. All is well and investors are behaving in a way that indicates they expect these conditions to remain.
So why would a financial advisor upset the apple cart and introduce the possibility of negative change? Why would they put themselves in the position of asking clients to alter their strategy when things are going well? Potentially, that would create turmoil and argument – advisors could potentially lose clients who are currently happy as clams.
Here's why: Part of the role of financial advisors is to look to the future on clients' behalf.
"Easy for you to say, Larry," advisors might respond. "What experience do you have in dealing with clients, many of whom think they know better than I do? What do you know about handling them in times of crises, of listening to them complain when they are upset that their funds aren't keeping up with the market returns over the past six months or a year?"
And they'd be right. I have never been in the seat of an advisor dealing with emotional, undisciplined investors.
But my 38 years in the investment business has taught me to spot an environment, from the standpoint of valuation of equities, at a high-risk level.
Yes, it's been a wonderful run that has barely seen a correction in U.S. stock markets in almost nine years. Stock valuations are as high as they have been in a very long time. The CAPE Ratio, a valuation measure created by economist Robert Shiller, is trading at just over 30, only exceeded twice before: 1929 and 2000. And, who knows? This trend of even higher stock prices ahead is entirely possible.
Nevertheless, just like our unfortunate frog or Thanksgiving turkey, I believe advisors have to be prepared for unforeseen change or a black swan event. Do we know what will happen in any precise way in the future? Do we know the date markets could turn negative? Of course not. The fact is, no one can tell you these events with any degree of certainty.
The good news is that you don't have to know. Just prepare for that eventuality. The future will unfold in its own way in its own good time. The most dangerous assumption you can make, as many of your clients do, is to think the world unfolds in a straight-line fashion and markets will continue to keep advancing. The turkey has no reason to believe that day 1,001 will be any different. All is well in her universe. What evidence is there that tomorrow will be any different?
But Thanksgiving is fast approaching – Oct. 9 in Canada and Nov. 23 in the United States – and the water in the pot is getting hotter.
Advisors have a responsibility to have difficult discussions with clients and prepare them for radical, unpredictable and financially destructive changes. Markets can shift direction in less than a moment's notice. My article in late May showed such events occurring over and over during the past 116 years with calamitous losses repeating time after time for hapless, unsuspecting and vulnerable investors.
Advisors are paid by their clients to have uncomfortable conversations with them while they are calm and rational. When markets retreat, history has shown repeatedly that clients can end up eating a Thanksgiving dinner, or end up on the plate.
Larry Sarbit is the chief executive and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a subadviser on three funds for IA Clarington.