Which tools will let me develop a robust investment policy?
Financial market developments are completely unpredictable. Scenario thinking will help you identify real risks and tailor your investment strategy to what is actually happening.
By Stefan Lundbergh, director of Cardano Insights
Financial markets are inherently unpredictable
The phrase ‘casino pension’ is indicative of the uncertainty felt regarding pension benefits, but comparing financial markets with a casino is a slightly reductive. In a casino, after all, you know the odds and they never change. Financial markets, on the other hand, are unpredictable and inherently unstable. This fundamental uncertainty allows for higher expected returns to gambling in a casino, but to gain insight into the many risks involved, investors require a wide range of tools.
Financial markets are driven by a multitude of emotions and collective psychoses of investors that are rooted deeply in our reptilian brains. As such, we are forced to accept that returns do not follow a stable, statistical distribution. There are no unified mathematical models for investing in a fundamentally uncertain world, so we have to work with a wide selection of tools and involve people with different views in the decision-making process. The trick is to combine all the information we have at our disposal to help us make investment decisions.
Drawing up future scenarios is a particularly crucial tool that consists of using widely different sources to predict possible (extreme) futures. For each version of the future, we determine how it would affect the funding level and the future of the scheme and/or pension fund as a whole. By compiling a modest collection possible futures, we can cover a wide variety of possible outcomes, provided each individual future substantially differs from all others.
Memories of the future
Scenario thinking has two key positive effects on a pension fund’s investment policy. First, it lets us take pre-emptive measures to protect ourselves against the consequences of a particular scenario. Second, by considering how we would adjust the portfolio to each different worldview, we become adaptive, creating ‘memories of the future‘, as it were. When a certain scenario does unfold, our ‘memories’ will help us adapt to the situation quickly, so that we can make well-informed investment decisions.
The world keeps turning
Working with scenarios is never a one-off exercise, because the world just keeps turning. Managing uncertainty is an iterative process in which you have to keep testing your portfolio and must have the courage to make the necessary changes. The future will always be unpredictable, so there’s no such thing as a guarantee, but there are ample opportunities to limit risk and curb fluctuations.