We join an annual client meeting at a mythical advisory firm that bears only a passing resemblance to our own.
Advisor: Good morning, Mr Smith, it has been a year since we last met and I thought now would be a good time to go through our annual review of your finances.
Client: Fair enough, let’s start with Brexit; what are your ideas of how to avoid losing money. I read recently that the UK could see an economic disaster over the next decade and I don’t want to own UK assets in that scenario. How are we going to change my asset allocation to avoid a decade of losses?
Advisor: We focus on what we know; if you google “Brexit disaster for UK” you get 21 million hits but they are forecasts not facts- if you remember, Mr Client, doom and gloom was predicted immediately, should the people vote for Brexit, with the Bank of England warning of higher inflation and unemployment alongside lower economic growth and Sterling should the populace vote “Leave”. The whole economic establishment rallied round, with the IMF also forecasting a recession, as did nearly all the City (1). Not only did they ALL get the effect on growth and markets wrong, they got the direction of travel wrong too- the FTSE All Share is, despite recent market woes +16.8% since the vote, whilst growth, although not spectacular, has been in essence unaffected since June 2016, as the chart below shows. The Q3 UK GDP number was the highest growth rate since Q4 2016, with pay growth and unemployment both moving in the right direction. This may not last, but it serves to underline that the Armageddon prophecies were, at best, premature.
Client: Yeah, OK, but these forecasts can’t ALL be wrong- these people are professionals, who spend all day looking at this stuff- they must know what they’re doing surely?
Advisor: Well, investments is one of those areas in which hard work, diligence (and even intelligence) does not necessarily pay off in superior forecasting performance; “experts” have a, shall we say, “spotty” record in terms of accuracy, (2), partly it seems, because they, unlike plumbers or bridge designers, (whose leaky pipes or collapsed bridges are immediately and publicly apparent) don’t bear any business consequences for their predictive failures- they have no “skin in the game”.
The Dunning-Kruger effect is a well-known cognitive bias, whereby those who tend to be more aware of their subject (whatever it is) are also aware of the limitations of their knowledge- whereas those that know less tend to be more certain of themselves (and shout louder). In the Twitter age, a nuanced view, which accepts that knowledge is bounded by biases, information deficiencies etc. is drowned out by definitive statements, which implicitly assume no margin for error in their interpretation of events.
Client: I see your point- but that doesn’t mean it won’t happen; maybe they were just early…
Advisor: Well, in investment terms there is very little difference between being “early” and being wrong. Experts often say that they were merely early in order to justify their errors, but of course they aren’t the ones who bear the consequences of this mistake. Investors are.
Client: So, what should we do?
Advisor: Nothing. A stock market, like the economy (and the climate) is a highly complex organism, which constantly evolves due to a myriad of diverse (and sometimes contradictory), drivers which no individual can possibly anticipate, let alone explain. Most ex-post explanations for market movements are merely attempts to link two (unconnected) events to create a “story” to explain an event (the post hoc ergo propter hoc fallacy). The market reaction to the Trump election win, the Brexit referendum and the constant refrain from Ben Bernanke (the then Fed Chairman) in 2007, that “mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency,” that he expected no spill overs from the sub-prime mortgage market collapse and that the Fed was not forecasting a recession. The (potentially unsettling) truth is that nobody did because nobody can. And if they cannot, nor can I.
As a consequence of this, the investment advice equivalent of the medical axiom of “primum non nocere” (first do no harm) applies. Selling out of investments to avoid a loss, even if it works, then faces the task of when to get back in to that particular region/asset etc. Thus, TWO correct decisions need to be made to actually see any benefit from the plan.
Look at the chart below; had one sold out in June 2015, anticipating the result (which virtually no-one did), one would have missed out on the subsequent net 15% gain thereafter. At what point would it have been prudent to get back in? Even if one had bought the market at the low point of March this year, the current return is just 1.05%. The psychological pressure to get back in to the market creates enormous potential for error-compounding (as one error begets another).
Market-timing rarely works and it creates as many (long term) problems as it solves in the short run. We thus see no reason to try to second guess the collective intelligence and knowledge of the markets; on the contrary, we are harnessing the “wisdom of crowds” by allowing market participants to arrive at a collective decision that will almost always be superior to that arrived at by individuals. It does not mean that the markets will always be “right” (whatever that means), as information is being constantly assessed, assimilated and (re)- interpreted, but to engage in market timing is to positively assert that one knows more than the vast numbers of well-informed, diligent and highly competitive participants out there. What do WE know that the market doesn’t…?
Client: I get it. So should I ignore the Brexit drama completely then?
Advisor: Probably yes. But if you must follow it, I suggest treating it as the soap opera that it largely is, (with the caveat that soap operas sometimes resemble reality). As the 13th Century medieval proverb says, “this too shall pass”.
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.
The views expressed in this article are the author’s own and not necessarily those of EBI Portfolios Ltd.
Providing Investment management & supporting resources to a select group of UK and European financial advisers who have embraced evidence based investing.
- Note that all the above links were from the Guardian, a strongly pro-Remain newspaper, which might just have had an axe to grind in this matter.
- At the risk of missing out on a Central Bank Christmas Card this year, the following table shows the ranking in terms of economic forecast errors. None of them could be described as Nostradamus-like in their predictive powers.