Introduction

One of life’s many lessons is that nothing is certain but uncertainty. As institutional investors, we are apt to forget this during normal times, and especially during bull markets. As a result, we seem fated to relearn it during the crises and sharp downturns that history shows are a regular, albeit infrequent and unpredictable, aspect of long-term investing. To varying degrees, we were all lulled into complacency about the risks we face as investors during the lengthy and relatively calm period from the early 1980s to 2007 — a period sometimes referred to as “the Great Moderation” — when economic growth was reasonably steady and markets were mostly well-behaved. Many of us began to believe that we had entered a new era in which market risk was much reduced by modern financial instruments. And as strong market gains and stable economic growth became the norm, many of our beliefs evolved into certainties. We became certain that financial innovation was nearly always a good thing; that the growing use of complex derivatives helped spread portfolio risk; that housing prices were destined to slowly and steadily rise; that our financial regulators were at their post and on the job; that the complex mathematical models used to measure risk were insightful and accurately constructed; and that the global financial system was founded on a rock of enlightened self-interest, not a quicksand of regulatory inattention, academic theories untested by long-term experience, fraud and socially destructive greed.

To be sure, there were market ups and downs during this period (and even a brief crash, for those whose memories go back to 1987). It wasn’t all rosy. But there was nothing in it like the crisis we experienced in 2008. We have to go back 70 years to find a parallel for that, long enough for several generations of professional investors to have come and gone, lulled into a multi-generational false certainty about how markets work.

So it’s not surprising that, for nearly all investors on the job today, the last two years brought home the reality of investment risk and uncertainty in a shocking way. In 2008, we were shocked by the sudden onset of a global financial crisis, the severity of market losses, and maybe most of all, by the failure of asset class diversification to protect portfolios. Almost as surprising was the strength of the market’s rebound from the nadir of early March 2009, when it seemed as if the global financial system itself was crumbling under our feet. But despite the vigor of the year’s partial recovery, the residual impact of these tumultuous events has left us all — participants and those of us at CBIS — with more than the usual dose of uncertainty about the future.