The Uncertainty Principle

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We at Kennox have serious concerns that new regulations and laws are being written at present which add to the complexity of the financial system and increase red tape yet do little to prevent another recurrence of the troubles of the last few years. We would highlight that lawmakers and regulators are ignoring a simple but fundamental principle.

One of the most basic underpinnings of our financial system must be that there can be no certainty. Uncertainty will ever be with us. In other words, one cannot avoid risk, one can simply manage it. This means that there is no banking or financial system that can be guaranteed to never fail. Banks are inherently risky due to the maturity mismatch between deposits, which can be called at any time, and loans, which are legally contracted for longer periods of time. If enough people want their deposits back at the same time, any bank in the world is immediately bankrupted. Banks depends on a confidence trick – if confidence is questioned enough that a significant percentage of their depositors redeem, the bank will implode. Nor can governments guarantee an entire financial system. The financial system is much bigger than any government, and, if the problems are large enough, the government will be swamped.

As humans are imperfect, any system designed by humans is destined to be imperfect. Thus every financial system must be designed with the understanding that crises can and will happen. This is what happens when imperfect systems and risk meet. All regulators and law makers need to remember this core tenet when redesigning the financial markets. We are convinced that they are not doing so. Without it we are destined to repeat the mistakes of the past, and the sooner we address this, the better.

There are lessons from this uncertainty principle for investing as well. A very good way to understand uncertainty and risk in financial markets is to consider investing for the longer term. If the goal of a long-term investor is to protect the buying power of their capital (the minimum rational goal), that investor MUST bear risk. There is no long-term risk-free asset. Consider cash. In the longer term it is a very poor investment as inflation erodes away the buying power of money (remember what £1000 pounds bought in the 1950s – a house? Now – a month’s rent?) As for equities, any investor with any sense of history will know of the risks there. Just look at 1929, 1987, emerging markets crisis of 1997/8, tech bust of 2000, post-Lehmans in 2008, or indeed the times when investors lost all (the German or Japanese stock markets post WWII). Bonds equally have delivered terrible returns at times as inflation has ravaged their value (such as the 1970s). Index-linked bondholders bear indexation risks, and counterparty risk (yes, governments do default).

We cannot predict the future. This means there is no risk-free option. As a society, and for so many individuals, we long for security, for certainty, to know. However, that it is uncomfortable doesn’t mean we can ignore it. Facing up to this fear is one of our biggest challenges and is the fundamental starting point for a robust investment philosophy. As we said before, we cannot avoid risk, we can only manage it.

Lawmakers or regulators must keep this uncertainty principle at the front of their minds. Investors likewise will have a much better chance of succeeding in their investment goals if they do likewise.