Is the worst yet to come for the economy?

When it comes to investing, biases typically don’t do anyone any favours. Even a bias for optimism could be negative — an idea worth exploring given that the benefits of optimism typically get all the attention.

“There’s a whole bunch of evidence that shows if you’re an optimist, life is just better,” said John De Goey, senior investment advisor and portfolio manager with Wellington-Altus Private Wealth Inc. in Toronto. “Optimism is great for most people almost all the time.”

Optimism bias correlates to positive outcomes like longevity and resiliency, research finds.

Optimism bias could also correlate with positive outcomes in investing, given that market history is a story of compounded real returns over the long term. Optimists stay invested and eventually reap the rewards.

Except when they don’t, because optimism bias comes with risk: “If there’s one instance where [optimism bias] would be dangerous, it’s when times are tough and we aren’t psychologically prepared for it,” De Goey said.

Given the pandemic fallout of high inflation, rising rates, economic uncertainty and steep government debt — along with rising risks such as geopolitics and climate change — tough times could be coming. Investors could face a prolonged downturn, De Goey suggested, unlike the brief bear market in March 2020.

“We were out of that so fast,” said Kevin Burkett, a portfolio manager with Burkett Asset Management Inc. in Victoria, B.C., referring to the Covid downturn, which he considered a fire drill.

Covid was “an opportunity to practice what it’s like to see account values falling and how clients respond and how we should respond with them,” Burkett said.

Since the pandemic began, De Goey has discussed risk in quarterly newsletters to clients. “I’ve been consistent in saying I don’t think we’re out of the woods yet,” he said.

He thinks it’s important for advisors to consider the potential for a serious market downturn, including developments that could catch clients off guard, such as a simultaneous drop in other assets like bonds and real estate. To do this, advisors will have to overcome the industry’s tendency toward optimism bias, De Goey said — a topic he tackles in his book Bullshift, to be published in January.

But he described his stance as more inquisitive Columbo than fearful Chicken Little. He suggested advisors consider a couple questions: “Are you concerned about this [market backdrop], and if you are, what are you doing about it? If you’re not, why not?”

Thinking about what could go wrong and how to mitigate potential losses is like conducting a pre-mortem, which researchers suggest helps avoid failure. For his part, De Goey said he’s being more conservative with client portfolios, within risk profile parameters.

He also suggested reviewing a client’s risk profile (defined as risk tolerance plus risk capacity, per the client-focused reforms).

When clients consider their risk tolerance (a subjective measure), they likely respond based on their life experience, De Goey said, which may not prepare them for what’s ahead. And since we know from prospect theory that the pain of a loss is twice as acute as the joy of a gain, “responsible advisors should be doing more to actively probe about how much of a loss a client can genuinely withstand,” he said, adding that those client discussions should happen before portfolios drop significantly.

When asked about the potential for the future to look very different from what we’ve seen in our lifetimes, Dan Hallett, vice-president and principal with Oakville, Ont.–based HighView Financial Group, suggested that concern may be beside the point.

“Everything feels unique and unprecedented in some way when you’re going through it” because of the uncertainty, Hallett said, recalling the downward grind and significant portfolio losses of the dot-com crash and great financial crisis. “Just your average bear market is pretty severe,” with “people under water for something like three years,” he said.

Still, he doesn’t dismiss the potential for something more serious than the average bear.

“Too many advisors don’t consider that bad things can happen,” Hallett said, though he understands why that’s the case: “It’s tough to be in this business … of advising individuals and planning for their future and not be an optimist at heart.” (Both Hallett and De Goey said they were optimists; Burkett said he liked to think he was neither optimist nor pessimist.)

Hallett said client portfolios are sometimes stress-tested for historical events like the Great Depression, depending on analysis goals. He also analyzes such scenarios as a client investing all their money ahead of a bear market.

In answer to the same question about the future, Craig Basinger, chief market strategist with Purpose Investments in Toronto, suggested change was a given.

More specifically, the next decade may be characterized by higher growth and inflation relative to the previous one, he said, given certain trends.

For investors, the bigger factor will be “a shift in what works,” Basinger said.

While simply holding assets and riding asset price inflation worked well over the last decade, in a higher growth and higher inflation world, real assets and companies with free cash flow will have a greater impact for portfolios, he said.

Burkett said he’ll continue to focus on the long term, and discern between temporary and permanent changes when making investments. A drawdown is an opportunity to show you’ve been investing based on fundamentals, he said. “If the market moves against you, you’ve put together a mix of investments that is all-weather enough” to still meet clients’ objectives.