The Independent Market Observer

Challenging Our Assumptions

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 17, 2022 12:29:24 PM

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assumptionsToday, I’m attending the Commonwealth Chairman’s Retreat conference. Of course, we’ll spend some time discussing business and the markets, but we’ll also get the chance to look at issues beyond that and into our own lives. Longtime readers may remember my column on gratitudes, where I talked about a Chairman’s presentation by psychologist Shawn Achor on how simply writing down three gratitudes a day could change your life for the better. I tried it, and it worked. I have now written down my gratitudes every day for several years, and there is no doubt it has made a very positive difference.

This year, there have been several insights along those lines, notably on how to evaluate your life. But today the one I want to focus on is more (but not entirely) market-based: the need to identify your assumptions.

Broken Assumptions

The point of this talk was that poor outcomes often come from misguided assumptions, which are adopted without question because “everyone knows” they are true. This is the MBA version of the Mark Twain quotation, “It's not what you don't know that kills you, it's what you know for sure that ain't true.” 

This is something that frankly haunts me because everything I do is based on an understanding of how the world works, and that understanding is based on a set of critical assumptions—that do not necessarily hold. Recent examples of assumptions breaking include that Europe was beyond warfare (see Ukraine), that medical science has put us past systemic risks (the Covid-19 pandemic), and that the global economy and modern financial management made inflation a risk of the past (see the most recent CPI and PPI reports).

The Flip Side

All of these are examples of assumptions that reversed in the short term. But the flip side of this is that even as assumptions break, we can’t simply assume the reverse will now hold. The war in Ukraine will eventually end, and the cause (Russia) will be unable to do it again. The pandemic continues, after significant economic damage, but the damage going forward will be much less. Inflation, while very high and very real, is caused by an explosion of demand and a collapse of supply, both of which are now reversing. In all of these cases, the prior assumption reversed but is likely to re-reverse to the status quo ante in the next couple of years. We can’t simply take current conditions as a good guide to the future. 

Risks and Opportunities

That means we need to look deeper. When we identify the assumptions, that is just the first step. Next, we need to understand the assumptions and where they come from. If we do that, we can understand what might go wrong—and identify opportunities. 

China and Asia. One that comes to mind immediately is the primacy of China and Asia. China has been the driver of growth for much of the world over the past 40 years and has driven growth in the surrounding countries as well. The assumption has been that growth will continue—but why? 

After all, the growth came from two things. First, the demographic trends provided endless very low-cost labor. Second, the open-world trade architecture allowed China to grow rich through exporting to the West. For the assumed growth to continue, either both of those must hold or new growth engines have to appear. In fact, of course, both of the original growth engines are, if not reversing, at least going neutral. China’s demographics are now mature and aging, not young and growing. The U.S. is now much less open to trade, especially to countries seen as strategic competitors. The assumption of continued growth looks less likely when you consider the underlying trends. This is the risk. 

And yet—and this is the major point—looking at that assumption still has value, because the assumption really doesn’t have anything to do with China; it is about the primacy of demographic trends and trade. That points us in a different direction. What about Africa? 

Africa. When you look at the demographic trends, Africa could be the new China with a large and growing young population available for hire at cheap rates. When you look at openness to trade, Africa is in a much better position with respect to the rich West than China now is. If you look at growth prospects, the assumptions that people think point to China now point much more directly to Africa. Is the assumption outdated? Not at all. But the interpretation certainly is. By identifying first the assumption and then the underlying reasoning, we can identify both the risks—and the opportunities. 

The Challenge Ahead

I will be spending more time going forward on assumptions, and the above, I hope, explains why. As the world changes, we need to identify what we know that simply isn’t so. That will be the big challenge for the next decade.

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