The 4 Best Ways to Reduce the Uncertainty of Investments
Too many times, we get so eager to make our money grow that a very important aspect of an investment is completely ignored. That critical aspect is uncertainty.
When we invest in any financial market, we must consider both uncertainty and risk. These factors are driven by the level of randomness that occurs in a given market. Uncertainty goes up as random events take place which affects market prices.
However, there is a notable difference between risk and uncertainty. Risk is a way of quantifying market randomness. Uncertainty is almost impossible to quantify, which makes it more dangerous.
Common Sources of Uncertainty
To maximize the protection of your investments, it vital to understand common sources of uncertainty in the markets. This is especially true when markets are experiencing high volatility, and when investors are closer to retirement age.
Economic Data Looks Backward and Not Forward
Any experienced stock market investor will tell you that how the market reacts to earnings reports is anything but predictable. The same can be said for all economic data.
A big reason for this unpredictable behavior is because economic data is reflecting the past. Markets react more decisively to information that occurs in the present or is forward-thinking.
Markets Hate Uncertainty More Than Bad News
We should never forget that the financial markets hate uncertainty far more than bad news. This is because outcomes from bad news usually come with a level of probability. Whereas, most uncertainty is random.
This explains why sometimes we see markets rise in the face of terrible financial news. While the news may have been bad, uncertainty was likely reduced in another significant area of the market.
Bond Yields Become Too Low to Sell Stocks
When market uncertainty looms, seasoned stock investors typically sell away part of their portfolio and buy treasury bonds. This activity has become expected in times of uncertainty.
However, as the coronavirus pandemic has gripped the world and caused markets to drop, bond yields are much lower than other times of financial crisis.
For instance, in October 2007, the 10-year bond yield was 4.7% during that market meltdown. But in February 2020, the 10-year bond yield was only 1.6%.
These low yields are causing investors to either liquidate positions or keep their funds in stocks.
Monetary and Fiscal Policy Announcements
All investors are painfully aware of that quarterly meeting of the Federal Reserve when they determine whether or not to raise interest rates. Short-term traders often make hefty trades around that time, while long-term traders might wait it out.
While the Federal Reserve announcement is not backward-looking like standard economic data, it often behaves the same way. This is due to certain players in the market anticipating the actions of the Feds.
We often hear investors say that the Federal Reserve announcement was already “baked into the market”, meaning they already knew what was coming.
4 Ways to Address Market Uncertainty
While the factors that create market uncertainty are random, there are measures we can take to greatly reduce the negative impact it will have on our overall investments. Here are four (4) ways that professional investors recommend.
Information Collection
Since market uncertainty occurs because we lack information, we can reduce it by gathering more information. With each one of our financial investments, we must stay abreast of the activities that are affecting the bottom line.
To get a complete picture, we need to assess both the fundamentals and technical factors of each investment. Fundamentals pertain to things like company news, actions of corporate executives, global events, and board of director decisions. Technical information pertains to items like price charts, moving average, oscillators, and P/E ratios.
Use Investment Models
Investment models are a great option for many investors, especially busy professionals. This is because in most cases, investment models are managed by outside firms so you won’t have to deal with the market directly.
The beauty of using investment models is they come in many varieties. Some models focus on growth and take larger risks, and some conservative models come with lower risk.
These investment models already have established sets of rules that are designed to maximize returns. Buying and selling rules are already determined for various kinds of markets.
Diversification
Another way to reduce the effects of market uncertainty is through diversification. If you buy one stock, then all of your risks depend on the uncertainty of that one stock.
However, when you buy a second stock, then your overall uncertainty is reduced. This is especially true when your second stock comes from a different market sector and is affected by different types of outside events.
Lowering Market Costs
A great way to lower your overall risk is by reducing the cost of the stocks you are holding. A method called “covered calls” is a great way to achieve this. For every 100 blocks of shares you own, you can sell an option against them.
Stock options are a time decaying entity. Buying stock options is like buying car insurance, you might use it, but probably not.
On the other hand, those who sell stock options are much more likely to profit. This is because the option’s time decay works in your favor.
Here’s an example:
Suppose you have 400 shares of ABC stock that are trading at $20 per share.
The current month is August and you notice that the October $25 CALL options are trading at $125 each.
You sell four (4) of those options and $500 is immediately placed in your account.
The only thing you have to do is hold the stocks until the options expire.
A person who bought an ABC October $25 CALL option has the right to buy 100 shares of ABC stock at $25 per share before the third Friday in October — when the option expires.
If the ABC stock price goes above $25, then the option buyer can “exercise” his or her option. As a seller, you have to sell them the stock for $25 per share. But kind in mind that it was trading at $20 when you sold the options.
This means you earned an additional (400 x $5) $2000 profit from the price increase, and you keep the $600 from selling the options.
Many stock investors wait for big rallies during times of uncertainty and sell CALL options against their stock shares. They wait for these options to expire, and then they do all over again with a new set of options.
Over time, their overall investment risk lowers considerably because they have lowered their cost per share.
Final Thoughts
Regardless of the markets in which you invest, uncertainty will always be present. The key is learning to recognize uncertainty and understanding when it has reached dangerous levels.
You must also be able to make a distinction between risk and uncertainty — even though they are both products of randomness.
When we are uncertain, it means that we have imperfect knowledge about the way a market is going to behave. Finding that missing knowledge is certainly the key to overcoming uncertainty.
