Working economic factors into investment decisions

tions that have a lot more to do with the “answer” than doesthemathitself.

For example, looking at the 2008 financial crisis from peak to trough and back again, there were so many moving parts that all contributed in some way to the market dislocation, many of which might not be present in the next iteration of a crash: years of easy money and lax underwriting in the real estate market, a lack of regulation in the banking sector resulting in “too big to fail” scenarios, the collapse of Lehman Brothers, the election of Barack Obama, and a Fed chairman who just happened to be among the world’sforemostexpertson the causes and cures of financial crises.

Who’s to say that that particular alchemy will ever appear again? A 2018 crash could be very different, resulting from wholly different causes and effects in the chain of investment experiences.

Thus, to plug numbers into a supercomputer and declare how a particular investment (or portfolio) would fare under something as broad as a future “2008 crisis” — and to two decimal places — lacks any probative value and is nothing but an exercise in meaningless mathematics.

Rather, we prefer to deal with stress-testing analysis that, while far less precise, is probably more useful. We think of everything in terms of a -3 to +3 scale, where zero is neutral, -3 is “very bad” and +3 is “very good”. In this light, a crash in oil prices is necessarily “very bad” to an investment in oil stocks, while a decrease in interest rates is necessarily “very good” for long-dated corporate bonds.

Our goal, rather than to quantify gains and losses under difference scenarios, is to determine a weighted “good/neutral/bad” score for each economic condition across an entire portfolio, with the ultimate goal of having the weighted average for each factor hovering somewhere between -1 and +1 (“more or less neutral”), allowing investors to sleep relatively well at night.

For example, if I score each of my investments on, say, “interest rates go up”, I would hope that my portfolio would be constructed with enough investments that would benefit from an increase in rates as those that would suffer under the same conditions.

Although the “good/neutral/bad” approach avoids the quantification problem, and certainly adds an analytical tool (especially from a portfolio perspective), its usefulness must still be tested in light of the fact that it’s never the case in real life that one factor, such as interest rates, changes without affecting one or more other factors, such as foreign exchange rates.

For example, a simplistic view on oil prices would suggest that owning any oil stocks would be bad if prices were to decrease over time. But overlay on to that the possibility that oil prices might fall due to an increase in American production and reduction in American regulatory hurdles, all while the U.S. dollar would almost surely increase in relation to the Canadian dollar, and suddenly owning an America oil producer’s stock might not look so bad when expressed in Canadian dollars.

Similarly, it’s hard to imagine a world in which interest rates increase without a sound economy and strong stock market. In this light, simply saying that an increase in rates is “very bad” for long-dated corporate bonds ignores the fact that a strong market could lead to a decrease in corporate spreads that more than offsets an increase in base rates, thereby resulting in a scoreof0,ormaybe-1,asopposed to an automatic -3.

Here’s the bottom line: it is very worthwhile to look at your portfolio, and its constituent elements, and engage in a “what if ” exercise. It’s also incredibly important that this exercise demonstrate that your entire portfolio is not utterly dependent on any single macroeconomic factor that is entirely out of your (or your investment manager’s) control.

Once you have determined that you are, in fact, well diversified across “what if ” scenarios, trying to overcomplicate or oversimplify the problem through complex math or stand-alone factor analysis will either give you a false sense of security or faulty notion of where your risk lies and how it is managed.

Rather, you should strive to have an investment portfolio that is nuanced enough in its construction to withstand the interconnected variability in economic factors that are sure to arise.