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Whatever the weather – Things change, so factor a range of scenarios into investment thinking

25/01/2016

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

26 years ago today, the British Isles and much of Northern Europe were hit by hurricane-force winds in what has become known, at least in meteorological circles, as the Burns’ Night Storm. Despite its catastrophic effects, which included some loss of life in parts of the continental mainland, the storm’s strength and path had in fact been very accurately predicted by weather forecasters. 

Precision is not something for which that profession tends to receive much credit – people are more inclined to remember the big ‘misses’, such as Michael Fish on the BBC brushing aside a viewer’s concerns ahead of the Great Storm of 1987. On Burns’ Night 1990, however, people were about as well prepared for what was coming as they were ever likely to be – yet this was almost all down to luck. 

In those days, it was standard meteorological practice to, as it were, pile all your chips on red – in other words, to issue one forecast based on your best guess. Ahead of the Burns Night Storm, a weather research vessel just happened to be in the right part of the Atlantic to gather additional data that helped the forecasters to see their best guess was wrong and alter it to reflect the reality of what was coming. 

While this episode was therefore something of a lucky escape – both for the forecasters and those who acted on their revised prediction – the practice of relying on a single best guess has, more generally, often not served mankind all that well. To their credit, the meteorologists recognised this point and, in 1992, they changed the way they forecast the weather. 

They stopped making a single prediction, in which they placed all their confidence, and instead put in place what is known as an ‘ensemble forecast’. This is where meteorologists use their models to generate multiple scenarios of how current weather data might evolve in the future. Some scenarios might suggest a storm is coming, others might not – but at least people are now aware of the possibility. 

Where the meteorologists have led, however, many practitioners in the world of finance have yet to follow, with economists, analysts and investors frequently placing their faith – and, in the latter case, their cash – in single best guesses. Clearly that is fantastic if the guess proves right but, equally clearly, there will be a good many times when it does not – causing damage to reputations and, more pertinently, portfolios and pockets. 

Rather than being so arrogant as to believe you can know everything about the world, it surely makes more sense to factor a range of scenarios into your investment thinking so that, while you may be hoping for the best, you are at least prepared for the worst. Here on The Value Perspective, we aim to do that by investing in companies with strong balance sheets and cheap valuations. This gives them the capacity to weather – pun intended – difficult times and provides a margin of safety that can absorb the impact of adverse developments and protect us from permanent losses of capital. 

This value-oriented approach is a tacit acknowledgement of London Business School professor Elroy Dimson’s great observation that “Risk means more things can happen than will happen” – and indeed, given today’s date, of Robbie Burns’ own take on that idea: “The best laid schemes o' mice an' men gang aft agley.”

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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