War, uncertainty, and your investment portfolio
Updated: September 1, 2015
These are definitely challenging times for savers and investors, with the US stock market (still)¹ down from its peak and war in Iraq continuing. Whether we like it or not, investment returns are unpredictable and volatile. This is true at all times: peace and war, boom and bust, summer and winter. Unfortunately, despite many protestations to the contrary, there is no proven strategy for predicting the inherently unpredictable, nor is there a proven strategy for eliminating inherent volatility.
However, there are proven strategies for coping with both unpredictability and volatility. Those strategies are diversification and patience. Effective diversification requires selecting investments that tend to have returns that move independently of one another, so that when one is down, another is likely at least not to be down, and maybe even to be up. Patience requires recognizing that diversification works – not all investments will be up at the same time. Selling those that are down now, and buying those that are up is … selling low and buying high – the reverse of the old saw about how to make money in the market!
Diversification and patience are difficult strategies for us humans because they seem to be so passive. We want to choose the winning strategy that will “shoot the lights out”, not admit that we don’t know what it is. We want to act, not wait. But the data are strongly in favor of diversification (many securities not few) and patience (not market timing or day trading). Diversification and patience are the right strategies in these times of war and uncertainty as well.
In Global Investing, The Professional’s Guide to the World Capital Markets (1993), noted investment performance expert Roger Ibbotson and leading institutional investor Gary Brinson show that historic US equity returns after inflation in times of war have been only slightly lower than in peacetime. They also note that inflation has been significantly higher during wartime. This finding suggests that inflation-protected securities may be especially appropriate to consider in the fixed income component of portfolios in wartime.
Specifically, Ibbotson and Brinson indicate:
- Economists and analysts do not agree whether equity markets perform better or worse than usual in times of war.
- Theoretically, arguments can be made on both sides:
- Markets should perform better because of extra economic activity to support the war effort.
- Markets should perform worse, because a lot of the extra economic activity is not productive (weapons and fighting do not support consumption).
- However, the data suggest that real equity returns are neither significantly better nor worse, based on analysis of equity market performance during 8 US wars of the 19th and 20th centuries.
- Real returns averaged 7.7% during wartime, 8.6% during peacetime
- Inflation averaged 6.9% during wartime and .5% during peacetime
- Unfortunately, their analysis does not assess market volatility in times of war vs peace.
- Holding cash is riskier in wartime than in peacetime (because inflation tends to be higher).
- On average, holding equities seems to produce similar returns in war time as in peace time.
- Investment performance in war time is no more predictable than in peace time, for better or for worse.