Creating certainty in an uncertain world

April 2016
Behavioural_paper game_small
All of us have experienced that the financial markets are both uncertain and unpredictable.

This is also the theme of the Boom Bust Boom documentary which outlines that our human nature is the driver of financial bubbles. This is in contrast to the neo-classical financial theory we were taught in school which assumes that humans are rational and that markets always return to equilibrium. In that theory, booms and busts simply cannot happen. There are other economic theories that do integrate human nature and from these we can learn that boom and bust cycles are part of normal life and that the economy and financial markets are inherently unpredictable.

This discussion seem a bit academic, but it has a large impact on how we manage pension funds. The common wisdom that it is optimal in the long-run to hold a static asset mix is derived from the neo-classical theory. The same theory also asserts that there is a long-term average interest rate. Since the world is uncertain and unpredictable, the static asset mix should not be regarded as a safe haven for a pension fund and we should not expect interest rates to mean-revert to a long-term equilibrium. The common wisdom has led to very volatile funding ratios for defined benefit (DB) pension funds.

So what can we do to navigate an uncertain and unpredictable world? A first step is to avoid taking the unintended risk that arises due to liabilities. It is better to hedge that risk away and reallocate the risk budget to risks that we intend to hold. The issue here is to consider assets versus liabilities, since this allows you to understand and manage risk better.

When taking intended risk we should try to avoid the biggest losses and only take risk when we are appropriately rewarded for it. Although we cannot predict the future there are patterns emerging and evolving over time. This means that we can assess how the economy and financial markets can potentially evolve in the near future. Following this, a long-term investor should dynamically adjust their portfolio as the economy and financial markets evolve over time. This must be done carefully since we need to be prepared for when we, from time to time, are wrong to ensure that the funding ratio is robust. In the figure below we can see that the results of applying this approach to investment is quite encouraging compared with following the conventional wisdom and holding a static asset mix.

Would it not be good knowing that there will be no large swings in your funding ratio?