Butterfly vs Mosquito Effect
Most of us are familiar with the butterfly effect, which is defined as the idea that small things can have non-linear impacts on a complex system. The often-cited example is that of a butterfly flapping its wings and causing a typhoon in a different part of the world.
While not an established concept, we can borrow that idea with the ‘mosquito effect’, defined as how small events can have unexpected outsized and far-reaching structural consequences in the long term.
While seemingly insignificant, mosquitoes top the league table of the most dangerous animals, trumping lions, scorpions or sharks, killing more than a million people each year.
Yet they are often underestimated or at the very least, misunderstood.
The word malaria, for example, comes from the Mediaeval Italian “mala aria”, meaning “bad air”. This mis-diagnosis in the early days allowed the unchecked and rampant spread of the deadly disease by mosquitoes amongst an unsuspecting population.
In the book “The Mosquito: A Human History of Our Deadliest Predator” by Timothy C. Winegard, he asserts that mosquitoes caused the failure of the 1698 Scottish expedition to Panama, which eventually led to the birth of Great Britain.
As a war historian, Winegard argues that deaths caused by mosquitoes far outnumbered, and were more decisive than deaths in battles. Examples include turning the Mongolian armies of Genghis Khan away from Southern Europe, saving the Holy Land from the European crusaders etc.
Causation in finance is often multifaceted, with a web of interconnected factors shaping market trends, asset prices, and investor behaviour.
Just like the transmission of diseases through mosquito bites, a chain of events can occur in the financial world, where one minor occurrence triggers a cascade of reactions, leading to significant shifts in markets or portfolios.
Nevertheless, in the short term, investors could be blindsided by such occurrences due to behavioural bias, inertia or complacency i.e. is this time really different?
Tightening monetary policies, increasing geopolitical tensions, deglobalisation, inflation and climate change are some of the structural forces expected to impact the investment environment in the long term.
Exacerbated by the pandemic, some of these seismic forces are already on the horizon, although the implications are yet to fully manifest.
How do these shifts impact the construction of investment portfolios?
Portfolio Construction Imperatives
The Future Fund, Australia’s sovereign fund, recently published a position paper on ‘The Death of the Traditional Portfolio Construction’, signalling the new investment regime.
As investors anticipate a world of lower expected return, heightened inflation, increased conflicts and undue government interference, it is imperative to question whether traditional capital market assumptions and models continue to hold true.
The inefficacy of the stock/bond correlation, driven by inflationary pressures due to supply shocks, has also prompted investors to re-examine diversification measures.
Inevitably, investors may be expected to embrace a differentiated approach to extracting equity risk premia, calibrated accordingly to the individual fund objectives and risk appetite.
These may include:
- Higher tolerance of illiquid assets
- More dynamic and flexible strategies
- Pursuing high conviction, opportunistic and idiosyncratic exposures
- Higher propensity to access skill-based investments
We look forward to a robust discussion on asset allocation and portfolio diversification at the 9th annual Global Investment Strategy Forum for asset owners and intitutional investors in the Asia Pacific region.Enquire about this event