Unknown Unknowns, and the Risky Business of Avoiding Risk!

"It's not what you don't know that'll hurt you; it's what you do know that just ain't so."

Mark Twain

"The fellow that can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one that can see years ahead, he has a telescope but he can't make anybody believe that he has it."

Will Rogers

"I would not say that the future is necessarily less predictable than the past. I think the past was not predictable when it started."

Donald Rumsfeld, US Defense Secretary

"Learn to say 'I don't know.' If used when appropriate, it will be often."

Donald Rumsfeld, US Defense Secretary

"Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know."

Donald Rumsfeld, US Defense Secretary

To which I say, I think I know what he means, but I don't know that I know.

This issue of Focus on Investments examines predictability, risk, and guarantees.

In 1988, Mikhail Gorbachev became Premier of the Soviet Union. Now, if someone had suggested at that time that the communist Soviet Union would collapse within two years, you'd have thought they were mad. Yet down came the Berlin wall, and in a few weeks, 40 years of the Cold War were relegated to the history books. I'm still amazed that such a stupendous turn of events could have taken place so rapidly, and yet - lo and behold! - within a few weeks it all seemed so very normal. If nothing else, this event proved that humans are certainly an incredibly adaptable species.

What about another huge, unforeseen change - the Internet? Science fiction writing has been remarkably prescient at predicting the future of technology. Computers have been featured in many science fiction novels, going back to the 50's and 60's, such as 2001: A Space Odyssey. But computers were usually depicted as storage retrieval and computational machines, working alone. To my mind, there is little in pre-internet science fiction to suggest the idea of an infinite internet-type network of computers sharing information. Yet now it seems so obvious - paying bills online, email, web search engines, ecommerce. All undreamed of a few short years ago.

But never mind the Internet, what about computer viruses! Computer viruses are very bizarre when seen in an historical context. Who on earth would have predicted that there would be a marvelous, widely disseminated new technology available to the world - the Internet - and yet a small number of techno-vandals would raise vandalism to heights that their paint-can wielding cousins could never have dreamed possible? And all it would take were a few keystrokes from somebody's home computer! Think about it: the invention of electricity did not result in vandalism of exposed, vulnerable electrical wires, nor did the invention of the automobile result in the widespread slashing of tires, yet we now have a constant threat emanating from a few devious, yet brilliant, nerds-gone-bad.

Finally, here's another completely unforeseen virus - SARS in Toronto. No one imagined that a first-class city like Toronto could see tourism devastated by a flu imported from Chinese chicken farmers. If you were considering making an investment in a Toronto Hotel prior to SARS, what factors would you have looked at? Probably the cost of construction, nearby competition, location, real estate prices, tourist arrivals, economic growth, etc. The arrival of an infectious disease just wasn't on the radar screen of anyone prior to its happening, but that didn't stop it from coming.

I must confide that I have long harbored my own 'pet' worry - a tsunami in Lake Ontario! Even before the Asian Tsunami, I wondered if it was possible. I did a little research on the Internet, and discovered that scientists have determined that tsunamis can indeed occur in large inland lakes! I got this from NaturalHazards.org:

A tsunami is traditionally defined as a series of ocean waves with very long wavelengths that can travel great distances. However, tsunamis can also occur in inland seas, such as the Mediterranean Sea. They can also occur in large lakes; recent geologic studies of Lake Tahoe in the U.S. indicate an active fault system which may produce a tsunami when an earthquake occurs. … Although they are rare, tsunamis do occur in the Atlantic Ocean, Mediterranean Sea, and large lakes.

And believe it or not, there are fault lines under Lake Ontario. Good grief, what next?

These are all examples of unknown unknowns: completely unexpected events that are exceedingly hard to predict. And they occur in investing all the time.

A hundred years ago, railroads were considered the blue chips of the day - safe and secure - an investment for widows and orphans. Unfortunately, most of them went into terminal decline, ending in insolvency and bankruptcy when other forms of transportation became faster, cheaper, or more convenient. What appeared safe ended in disaster.

Newspapers were once thought invincible, yet the arrival of television, specialized classified advertising publications, and more recently the Internet have all rendered traditional newspapers vulnerable to long-term decline.

Of course, the opposite has occurred too. Remember the bailout and revival of Chrysler in 1979 - 1980? Things couldn't have looked much worse for Chrysler back then, but then came the bailout, and the stunning success of minivans, and the rest is history.

So how can you prepare for these events? How can you both protect your portfolio from being devastated, while remaining able to take advantage of surprisingly good events?

Diversify: do not over-concentrate your portfolio no matter how great something looks. Anyone who had a well-diversified portfolio in 2000 would have experienced a bit of a downturn at that point, but would almost certainly have seen their accounts rebounding to new highs relatively quickly, just a few years later. Why? Because although developed-country stocks have in many cases not yet reached new highs, emerging markets have done well, bonds have done very well, as have commodities, income trusts and real estate. People who got really hammered a few years ago had far too high a proportion of their assets locked in one area - far too often, in the currently popular asset, which was technology at the time. I feel that today some investors are doing the same thing with income trusts. Risk comes not predominantly from the type of investment being made, but from the amount invested in it.

Buy cheap countries with a negative outlook that can turn positive.

You've got to go out on a limb sometimes because that's where the fruit is.

Will Rogers

Where in the world would you least like to invest? Africa? The Middle East perhaps? Did you know that over the last few years, the best performing stock markets in the world have been in Africa and the Middle East? Egypt's stock market is currently up 56% from the end of last year. Why not invest in the Caribbean? Russia? Turkey? Viet Nam? Don't you suppose that these countries are going to have significantly different economic fortunes that that of Canada? Of course they will. Huge numbers of Canadians invested in Nortel and tech stocks on the advice of the so-called 'experts' when it was actually incredibly risky to do so. So when these same pundits avoid emerging markets because they are supposedly too risky, I must say, I feel completely comfortable ignoring them. In fact, if they agreed with me, it might make me nervous…

Maybe the big growth in the next 10 years will not be in China, or India, but in predominantly Muslim countries - perhaps in - of all places - the Middle East! Why not? For a number of years now, many of my clients have been invested in funds that invest in Israel. I am not talking about funds that have some Israeli holdings; I am talking about funds that are exclusively invested in Israel. Until recently, Israel was viewed with apprehension due to the bombings and security risk. It seemed like a very scary place to invest. Yet…what was not scary was the valuation. Israel has a large number of hi-tech stocks that trade at much cheaper valuations than elsewhere. After a long period of going nowhere, suddenly Yasser Arafat died, a new Palestinian leadership arrived, and - voila! - the Israeli market went up over 50% in 3 months.

Think of wildly different scenarios than are currently 'accepted wisdom'

Anyone growing up in the 70's understands the fear of unemployment. Yet likely we'll soon have exactly the opposite problem - not enough workers! Immigration will become a highly preferred public policy. This might create all sorts of new investment possibilities, from labour-saving devices, to employment agencies.

Or what if medical advances extended life spans by 20 years - what a disaster for pension funds! For public health care! How wonderful for the drug companies!

Ignore easy solutions that promise no risk

What do we mean by 'risk'? To most people, risk means the chance of a short-term loss, and its magnitude. But that is in my view completely wrong-headed. The true value of risk from an investment perspective should be the chance of failing to meet your ultimate investment objective, and the consequences of that failure. Therefore, if you require an 8% return from your investments to meet/maintain your retirement needs, a GIC is the most risky investment of all, because it is guaranteed to NOT provide you with the retirement income you require. In my opinion, guarantees are often expensive, and they guarantee poor returns first and foremost.

GICs are really nothing other than Bonds, issued by a financial institution. But unlike traditional bonds, these bonds are not 'priced' daily, so you never see price fluctuations, and there's a false sense of security, of never running a risk of a loss. Rest assured, if you buy a 10-year GIC today, paying 4%, and inflation picks up to 3.5% a year hereafter, you will be stuck in a pretty awful investment for the next 9 years. Your principal is guaranteed, but the purchasing power of that principal assuredly is not. I broker GICs, so I can certainly get you the best rate, but for anyone under 75, I don't recommend them given today's low interest rates. They are an exercise in slow financial extinction.

There has been tremendous interest in the past few years in guaranteed or principal protected securities, whose main feature is that you retain the hope of getting some growth, while after 5 - 10 years, you are guaranteed to get your money back.

Wow!

Hold me back from that one! Merely getting your money back after 10 years looks like a real loss to me. The fact that investors are lining up to pay through the nose for these things should tell you something. The financial industry has a distinguished history of creating hybrid products. Hybrid products combine the elements of two or more individual financial products into one, neat package. They are promoted as something spectacularly clever, whereas in reality they are nothing of the kind. What is clever is the ways they put two apples together, and make you pay for three apples.

One thing I can guarantee is that companies are profit motivated, that they invest with the expectation of earning a return higher than bank interest. I can also guarantee you that if a firm is reasonably well managed, and earns a positive rate of return on its invested capital, and is priced reasonably from the start, that over the long run the investor in such a company will also receive a very satisfactory return on his/her capital.

If you'd appreciate an impartial, confidential second opinion of your current financial situation, give me a call. I can promise you that I will give you an unbiased review, with a pre-disposition to preserving capital and seeking out under-valued assets that should appreciate over time. I have over 16 years experience in financial services, both in Canada, and in Singapore and London. Call me today for a free, no-obligation consultation. It will be well worth your time.

Sincerely,

Scott Swallow, HBA, MBA, CIM