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Saturday, 12 December 2009

A Sideways Look At ... The Randomness of Markets

Surviving Randomness on The Psy-Fi Blog

There are hundreds if not thousands of sites on the internet offering would-be investors self-help guides on how to become rich through investing in stocks. These cover the technical mechanics of investing, but generally fail to address the true art of the great investor, the management of one’s own state of mind.

Of course, here we swing to the beat of a different tune, holding fast to the syncopated rhythms of the mental processes within and between people which drive them to make investment decisions that seem often to ignore the basic logic of time and space. When examined closely it usually turns out that behaviour developed and honed to maximise our survival chances out in the real jungle is ill-adapted for the investment one. We’re frequently led astray by our instincts and unfortunately the markets trigger our reflexes all too often.

Here, then, is a selection of the Psy-Fi Blog’s thoughts on surviving the randomness of markets ...

Investing in the Rear-View Mirror

The first thing to note about all valuation exercises is that they’re based on historical data. You’ll often find some wisecracking smart-ass pointing out that this is the only kind of data we have – which is true, but is still no reason to use it like a finance minister predicting next year’s economic growth. The problem is we don’t have enough information because:
“... to get enough data to model the future we need to inspect the market events of all of the parallel universes where different conditions apply. So far we don’t know how to do that, although we’re trying to tunnel through by creating a Black Hole under Switzerland which we’ll start just as soon as we figure out where the contractors put the fuse box.” >> Read More
The idea that our understanding of the structure and order of the world is an illusion is extremely hard for people to accept. Most can’t, preferring quite rightly to live in a fog of forgetfulness rather than accepting the brutal role of chance in our lives. Yet if you want to be truly successful at the investing game recognising that trying to predict the future from the past is nearly always futile is a necessary, if not a sufficient, condition for success.

Black Swans, Tsunamis and Cardiac Arrests

The great proponent of the idea that randomness is the dominant theme of investment is Nicolas Taleb. Taleb’s contention is that great disasters occur far more regularly than the standard theories, based on extrapolation from past data, suggest. The relative rarity of these devastating events is what leads to the failure to anticipate them: people think that because such things happen only occasionally they can be ignored:
“Stockmarkets are classical territory for Black Swans and are where Taleb’s ideas originated. Although returns oscillate about a stable midpoint over many years out at the extremes we see many more surprises than you’d predict. Yet despite the relative regularity of these Black Swan events – think 1907, 1929, 1931, 1936, 1973, 1987, 1989, 1997, 2000, 2008 – most commentators and fund managers simply ignore them in any analysis of stockmarket returns.” >> Read More
The psychological condition that leads people to discount low probability, high impact events is known as Disaster Myopia and it seems to be a facet of the availability heuristic. Basically stuff that hasn’t happened recently gets completely discounted. Stockmarkets are particularly prone to this type of situation and every time it happens mentally unprepared investors lose huge amounts of money as their evolutionary fight and flight mechanisms kick in at exactly the wrong time.

Panic!

The sheer range of financial crises that have occurred is, when viewed from a historical perspective, quite extraordinary. Indeed there are so many of the bloody things it’s almost impossible to believe that most investors spend most of their time proceeding on the basis that something very bad isn’t about to go wrong:
“The list of panics and crashes over the past few hundred years is fearful. From 1720 up until the end of the twentieth century Kindleberger lists 32 – or one every eight years or so. Most of these were international in nature. For those people convinced that globalisation is a modern phenomena it’s a sobering read”. >> Read More
Unfortunately market participants fall prey to the Fallacy of Composition, in which everyone acting in their own self-interest ends up dooming the markets. Everyone assumes that as markets climb to ever more irrational levels that they will be able to flip their holdings to a Greater Fool. When everyone does this then everyone’s the Fool. And while this is happening there’s always someone out there explaining why it’s OK, because it’s different this time.

It’s Not Different This Time

The trouble is that it never is different. There are certain fundamental rules of investment logic that don’t go away no matter how much you twist and pervert them. Our current version of the Black Swan was founded on financial institutions falling prey to a standard set of psychological biases: availability, over-optimism, perverse incentives and simple self-interest were all it took to send us into our personal circle of market madness.

Hoping, however, that we can use this experience to prevent this happening again would be a triumph of unreasoning hope over evolutionary expectation:
“Of course, memories will fade, new systems of risk management will be created, overconfidence will kick in, the incentives to behave perversely will creep through the global network and one day we’ll have another crisis. I probably won’t be around to see another one on this scale but I absolutely guarantee that you’ll find earnest financiers explaining once more how that it’s different this time”. >> Read More
However, if you avoid the psychologically supercharged confusion of the mass markets and take a long-term view you can, at least, avoid the worst of the problems.

It’s OK To Lose Money

Despite all of the real problems that markets face if investors can steel themselves to ignore the mental confusion and frantic followers of investment fashion then it’s perfectly possible to trade though the irregular panics that occur. Acknowledging that we can’t foresee the future, and realising that nobody else can with any accuracy, no matter what the ‘expert’ label is they run with, is the start of developing an investment philosophy that can stand the test of time.
“The point about viewing stocks as earnings machines is that the cumulative effect of earnings being compounded has hugely beneficial impacts on investors’ long term wealth. Retained earnings should, all things being equal, lead to future company earnings increasing, while distributed earnings – primarily dividends – can be profitably reinvested in other earnings machines. Taken together the overall outcome is nicely satisfactory for investors who can afford financially and psychologically to take a long term view.” >> Read More
Following some kind of long-term strategy based on fundamental valuations and mixed asset classes will generally reap decent rewards. The trick is to understand the psychological determinants of our investing behaviour: and then learn to override them.

Depressed Investors Don’t Need Feedback, Everyone Else Does

That there’s a relatively simple trick for gauging investment performance which most people don’t use is almost an inevitable consequence of our inherent natures. If we spent a lot of time looking closely at what we said and did in the past we’d be horrified by the changes we’ve undergone. People just aren’t very good at accurately remembering what they did and there’s probably a sound reason for this to do with maintaining a coherent self-image.

Unfortunately this tends to mean we don’t much like cross-checking our own performance as it forces us to face up to our own inadequacies. Yet in those rare disciplines where this is enforced the ability of people to calibrate and improve their results is remarkable.
“The alternative is to continue to stumble blindly around in the hope that everything will turn out to be OK. If people insist on becoming active investors rather than passively letting the markets take their course, then they need to concentrate on improving their abilities. Experts get to be expert by practicing, not by simply wishing it to be so. Of course, if you accept the arguments of the more extreme proponents of efficient market theories then you’d conclude that this is a waste of time. However, that argument was roundly demolished many years ago some geezer called Warren Buffett in The Superinvestors of Graham and Doddsville which demonstrated that certain pre-selected investors were able to outperform the markets over many, many years.” >> Read More
If investors can force themselves into self-calibration and start examining their own decision making then they're half-way to a successful strategy. At least then their decisions should stand the test of the onslaught of real-world uncertainty, whenever it hits.

Ambiguity Aversion: Investing Under Conditions of Uncertainty

Still, before people can invest properly they need to learn to live with uncertainty. Most of us aren’t naturally very good at this and many of our mental processes are attuned to avoiding ambiguity. It’s genuinely difficult:
“Even experienced investors may fail to recognise the onset of uncertainty. The stockmarket collapses of the 1970’s as the world reeled under multiple crises certainly seem to have been such a situation. The sudden recognition of problems that had previously not been evident – oil supply worries, corrupt world leaders, flared trousers and glam rock – led to a whole host of reactions including, ironically enough, the first attempts to build risk management models to protect against such future events. The irony, of course, is that these models have themselves ended up contributing to the problems because they don’t – because they can’t – capture the nature of uncertainty.” >> Read More
Once we've recognised that uncertainty is with us always, especially when it seems to have been banished forever, then we're at least avoiding the perils of sleepwalking into failure. Having learned to calibrate ourselves to build decent investment portfolios the last thing we need is to be frightened into giving up our gains because everyone else is running scared.

Living in the Shadow of Doom

Understanding that markets are inherently unstable and that there’s always a crisis just around the corner is the starting point. Which brings us neatly back to the plethora of self-help investing guides out there. Different styles of investing will suit different styles of person and only trial and error will help you figure this out. But before launching out into the world of valuation metrics and trading signals it’s important for the novice investor to have some understanding of themselves.

If you spend a lot of time investing then if, at some point, you don’t end up facing a 50% loss on your investments from some artificial high you’ll be very, very lucky. How you deal with that will do more to determine the eventual returns you make than any clever investing tricks you pick up along the way.

As people entered through the portal of the great Oracle at Delphi they were confronted by a message above the entrance. All the advice that the Oracle gave was worthless unless the supplicants understood the meaning of that message, and it stands up well today as a summary of the essence of this article: “Know Thyself”.

2 comments:

  1. If every forecast was accompanied by its standard deviation it would be help users of the data to assess the riskiness of using that data.

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  2. I don't agree that we don't have enough data to learn meaningful things about how the market works. It would always be nice to have more data. But there is enough data to give us confidence that we know the essential points.

    The problem is that we have not yet been willing to accept what the data says. I think that may be in the process of changing with today's economic crisis.

    The essential thing that we need to know is -- Do valuations affect long-term returns? If "no," then Buy-and-Hold is the way to go. If "yes," then the opposite of Buy-and-Hold is the way to go.

    The data says that valuations have been affecting long-term returns for 140 years. There has not yet been one time in the record when this did not prove to be so (in the long run).

    The trouble is -- we all possess a Get Rich Quick impulse that persuades us that perhaps this will be the time when it will be different, perhaps this will be the first time that valuations did not affect long-term returns, perhaps this will be the first time that Buy-and-Hold works for the long-term investor.

    What it comes to is that Buy-and-Hold is a purely emotional strategy and we need to overcome that emotion to be able to appreciate what the historical data really says. More and more people are souring on Buy-and-Hold as the financial losses that result from it mount. So I believe that we may be getting there.

    We'll see.

    Rob

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