In this month’s note:
- Markets can neither fully price in nor price out tariff risk
- Investors should see uncertainty as an opportunity, since uncertainty is the driving force behind long-term excess market returns
- Risk cannot be eliminated, but disciplined investing means focusing on good risks over bad risks
Last week we sent out a note arguing that while trade policy is dominating near-term market moves, what’s happening with respect to America’s shifting role in international financial markets is really an acceleration of structural, longer-term trends that started in earnest during Trump’s first term. Leaving aside that long-term view, the focus for markets, for better or worse, is on tariffs. In fact it’s hard to think of any other time in history where markets were on a hair-trigger to respond to policy changes that for all intents and purposes are being determined by a single person.
So what do markets today have to do with Schrodinger? I am by no means a quantum physicist, so forgive the layman’s interpretation to follow. Schrodinger’s Cat is a famous thought experiment where an unfortunate feline is place into a closed box that contains a vial of poison, with a 50/50 chance of that vial being broken should an atom radioactively decay. As outside observers, we must consider the cat as simultaneously living and dead until we open the box and observe its true state.
Global markets now find themselves in that state today. As investors we can’t assume that the current tariff regime (145% on China, 10% on the rest of the world) will remain in place because President Trump has shown he’s willing to pivot on a moment’s notice. So we’re forced to consider investing through a lens of both very high tariffs and no tariffs at all; of course in reality it will likely land somewhere in the middle, but that middle ground is a sprawling expanse of a much wider range of potential outcomes than usual. We can say with a very high degree of confidence that if President Trump were to announce a complete reversal of tariffs, markets would rally immediately and dramatically, with the reaction to the 90-day pause on April 9th providing a preview. On the other hand, if tariffs stay where they are, stocks would likely need to adjust even lower.
Investing is about “good risk”
This paradox seems unusual, and in many ways it is, but at the same time it’s the perfect representation of the underlying nature of investing. Uncertainty and return are the yin and yang of investing – neither can exist without the other. Securities whose return is more certain (short-term bonds) have a lower long-run expected return, whereas those with more uncertainty (stocks) are very likely to return more over the long run, but with considerably more uncertainty in the path and ultimate destination of those returns. If we knew the future to the extent that there was no uncertainty left in stock markets, there would be no excess return – every asset would resolve to a price that would correspond to a single (and relatively modest) rate of return.
So in some sense, we should welcome uncertainty, because it is what enables excess long-run returns for those who manage that uncertainty well. This is precisely why we view managing risk and uncertainty as the core of our job as portfolio managers: we can’t eliminate risk, but we can use thoughtful, diligent analysis and introspection to focus investment decisions on good risks over bad risks.
If you’ll allow me some personal commentary, the concept of good risk is one I’ve thought about much more since becoming a parent. When my wife was pregnant with our first in 2020, my mother told me that having a child is like pulling your heart from your chest and giving it legs. This was a mildly terrifying prospect, but in my experience has been a highly accurate analogy. In one sense, I want my children to have a charmed life, free of physical or emotional pain. But I also know this type of sheltered childhood would stunt their development and leave them unprepared to take on the challenges of life. I can’t and shouldn’t attempt to protect them from all forms of risk, but I can and should help them take good risks. Even though my eldest son might fall and hurt himself, learning to ride a bike while wearing a helmet is a good risk; putting my 18-month daughter on a Harley Davidson is a bad risk.
As portfolio managers we need to maintain the same mindset. Good risks often turn out poorly, and bad risks often turn out well, but over time the good risks invariably result in superior outcomes relative to the latter. So when it comes to investing, what constitutes good risk? In our view, good risks come from 1) focusing on investing rather than speculating, 2) diversifying by asset class, sector and geography, and 3) conducting well-reasoned analysis to fully understand the nature of a given investment’s risk and return potential.
Investing over speculating
Investing is when an asset is bought based on a logical set of projections about the current and future profit that fractional ownership of that asset will provide. Speculating is more like gambling, where the decision to invest is detached from fundamental analysis. Investing can create a great deal of wealth over the passage of time even if the market takes years to “agree” with you, whereas speculation requires almost immediate validation from the market. Investing relies on the quality and profit-generating attributes of the underlying asset, whereas speculation relies on more and more people throwing money at the asset. As portfolio managers this means we will never chase a stock simply because it’s had a great run recently, unless the underlying fundamentals are improving to such a degree that we believe the positive performance is actually understating the future profit potential of the company. Speculating can be extremely profitable in short windows, particularly in periods of excess liquidity, but over the long run it’s a losing game. We view the rise of meme-stocks, meme-coins, NFTs and other purely-speculative investing vehicles as an unfortunate, destructive force that disproportionately affects young investors.
Diversification
The word “diversification” often inspires eye-rolls in periods like 2021 when virtually anything you could put money into is rising sharply in value. But when a 2020 or 2022 or 2025 rolls around, diversification is a saving grace. With just 7 companies constituting nearly a third of the S&P 500, we think US stocks are far less diversified than most assume. Diversification isn’t just about owning many different names, it’s about owning securities that behave in ways to mitigate the risk of the overall portfolio rather than add to it. After well over a decade of strong US equity outperformance, many investors are convinced that international equities are not needed – as we argued last week, we think this is an unwise assumption, particularly given the rapidly shifting fiscal spending picture in the US relative to the rest of the world. On the asset allocation side, scarcity assets like gold provide an invaluable hedge against broad uncertainty, and as a diversifier it’s proven to be worth its weight in…itself.
Fundamental analysis
No reasonable individual would ever buy a stake in a business without understanding the sales, expense, and profit picture for that business. Similarly, investing in stocks is buying a small stake in a large company, yet many investors make that decision on precious little information – sometimes based on feelings or intuition alone. Buying stocks in this way is more of a recreational exercise, albeit one that can result in decidedly unenjoyable outcomes at times. We are incredibly grateful for the trust clients place in us to conduct this analysis and to make thoughtful decisions and recommendations. We’re always happy to provide the underlying investment thesis for any name clients hold, and to outline the logic that underpinned its addition to the portfolio.
Cautiously adding good risk as uncertainty reigns
Although the points made above apply to investing at all times, Schrodinger’s Tariffs have provided an acute and immediate example of the nature of market uncertainty. In clients’ portfolios, we were pulling back on risk in Q4-24 and Q1-25 through defensive sector allocations and tactical cash weights. At the time this process felt like swimming upstream, particularly in November and December when euphoria seemed to be the market’s sole driving force. However, our view at the time was that the distribution of risks in markets was increasingly skewed to the downside, particularly among the names and sectors that had realized the best recent performance (tech, high multiple growth stocks).
After a sharp decline in US equities, we are finding more opportunities to add good risk into the portfolio at cheaper prices – however, we still believe a great deal of caution is warranted, and that risk should be added thoughtfully and selectively. We’re a long way from knowing exactly what’s contained in that box of tariffs, but by focusing on taking good risks while avoiding the bad, we can make sure that uncertainty works for our clients rather than against them.
Chart of the Month – Bullion Bull Market
Gold is the best performing major asset class so far in 2025, and it’s not close. The lack of clarity in trade policy and the global economy’s overall trajectory has led many investors to hide out in safer assets, and with the US dollar’s safe haven status wavering, many have turned to gold rather than bonds. Although this rally has been remarkably sharp, the increase in the price of gold (yellow) is still close to matching the overall growth in money supply (white) of the last 50 years.
In addition to acting as a safe haven in times of uncertainty, gold is a hedge against the consistent debasement of fiat currencies like the dollar or euro. The global financial system is designed in a way where a unit of currency declines in purchasing power relative to goods/services and fixed assets over time; this is why scarce assets like gold, undeveloped land, and art tend to increase in value over time, even though they are non-productive assets in the conventional sense.
