The U.S. debt ceiling debate has a defined time limit and a limited range of outcomes – pass or fail essentially – with roughly predictable market reactions. The situation is ideally suited to implement an investing framework from what, in my opinion, is the single best paper ever written for individual investors: Michael Mauboussin's "Decision Making for Investors".
Mr. Mauboussin has returned to Credit Suisse as Head of Global Financial Strategies after a long stint as Chief Investment Strategist at Legg Mason Capital Management. He is also on the Board of Trustees at the Sante Fe Institute, an independent research and education center.
"Decision Making for Investors" is one of a remarkably insightful series of investor papers written by Mr. Mauboussin while at Legg Mason. He emphasizes the importance of investment process rather than measuring outcomes:
"A good investment process relies on three central concepts: thinking in expected value terms – combining probabilities and outcomes – considering the role of time, and appreciating the pitfalls to making quality decisions."
With help from Warren Buffett, Mr. Mauboussin presents a simple mathematical method that we can apply to the debt ceiling.
The decision making process first involves assigning a probability for each potential outcome based on known facts (which are always incomplete, of course). For the debt ceiling, let's assume an eight per cent likelihood of debt default, a 20 per cent chance of a "kick the can down the road" extension of debate and a 72 per cent chance that the debt ceiling is raised before the deadline. This is my own rough estimation; it's not important whether you buy it.
The next part of the process involves estimating the market outcome in each of the three scenarios. For the sake of argument, I'll posit a 25 per cent downdraft for the S&P 500 if there's a debt default, a two per cent rally for an extension, and a seven per cent market rally if the debt ceiling is raised.
The final step is to multiply the probability of each outcome by the expected return. Our example looks like this:
Probability | S&P 500 Estimated Reaction | Risk Weighted Value of Investment | |
Default | 8 per cent | -25 per cent | -2 per cent |
Extension | 20 per cent | 2 per cent | 0.40 per cent |
Ceiling raised | 72 per cent | 7 per cent | 5 per cent |
Expected Value of Investment: | 3.40 per cent | ||
Using these assumptions, the expected value of an investment in the S&P 500 ahead of the debt ceiling deadline is reasonably low at 3.4 per cent. This suggests that investors should avoid gambling on the outcome of Congressional negotiations - which is a good rule of thumb anyways.
Mr. Mauboussin's decision making framework can, and should, be used by any serious investor before putting any of their hard earned savings to work in any asset market. It is a simple, disciplined method to avoid investing mistakes and to maximize returns over time.
Scott Barlow