Hope for the best, expect the worst

One of the more annoying features of investing is that is a forward-looking activity. You buy or sell with future expectations in mind, despite the fact that predicting the future is an extremely difficult thing to do. This can lead to bad outcomes. Or as the boxer Mike Tyson famously quipped, “everybody has a plan until they get punched in the face.”

And yet that doesn’t stop people from espousing opinions about what they believe will happen. In the past week, for example, it has been easy to find some analysts predicting peak inflation and a downturn in interest rates, with others saying inflation is going to stick around for much longer than anticipated.

Presumably one of these people will be correct but it seems difficult to know who to choose and their activities often seem to devolve into the bizzarro behaviour that Gulliver saw when he visited the island of Laputa. Unfortunately knowing this doesn’t solve the problem. We still need to make some sort of estimate as to what we believe will happen in order to invest.

It should be somewhat refreshing then to know that some successful investors pay little attention to these sorts of daily predictions. Former Fidelity manager Peter Lynch, for example, notes in his book One Up On Wall Street that “all the major advances and declines [in the market] have been a surprise to me”. Similarly, hedge fund manager Nassim Taleb writes in Fooled by Randomness about setting up a Bloomberg terminal to filter out predictive-type headlines.

Taleb is also famous for investing using a strategy that continually loses small amounts of money but then pays off massively when there is a large drop in the market. Setting up such a strategy is difficult to do but there are still lessons to be learned from it. Ultimately he is making a prediction that there will be a drawdown in the market. He is not saying by how much it will be or when exactly it will happen, but that at some point it will.

For investors looking warily at inflation today, another way of thinking about this might be “expect the worst, hope for the best”. There are investments we can make that can provide respectable returns if the macroeconomic outlook improves but still provide downside protection if it does not.

BBGI Global Infrastructure (BBGI) may be one such investment trust. The managers invest in government-backed availability style assets, with strong inflation linkage. This is not a standard equities portfolio, so it is worth reading more about the trust to understand exactly how it works.

Nonetheless, the basic mechanics are that the trust has contracts linked to inflation, meaning the income it generates from its infrastructure investments will rise if inflation increases. Another key component of this, is that those increases are not dependent on usage of the infrastructure, so the trust is immune from the risks associated with the price elasticity of demand. In simpler terms that means the managers do not have to worry that price increases for users of demand-based infrastructure will result in lower demand, and thus less revenue.

BBGI’s n investment recent results illustrate why this can be a useful strategy to have in a portfolio, with its inflation-linkage being responsible for a 7.6% increase in the trust’s NAV last year, although this was partially offset by a higher discount rate, reflecting higher interest rates around the world.

BBGI is relatively unique in the investment trust sector because of its focus on availability-style assets, which provides a fair degree of predictability of what the future might hold. However, it’s always worth considering holding a range of different strategies within an investment portfolio. After all, you never know what’s going to happen next.

Login to read more...