Too many investors are falling under the spell of false omens
Comment of the Day

November 16 2012

Commentary by David Fuller

Too many investors are falling under the spell of false omens

My thanks to a subscriber for this excellent article by Ian Harnett, managing director of Absolute Strategy Research, which was published by The Times (UK) today (subscription required but here is a PDF). The subscriber forwarded the article with this email comment:
"I thought the attached article from today's Times was a good reminder to stay calm and make sure we don't ignore the big trends when deluged by so much noise."

I agree and will discuss this below but first, here are some samples from the article, starting with the opening:

How many black swans have you spotted recently? The fall in trading volumes on stock markets appears to reflect a world full of potential black swans: eurozone collapse, US fiscal cliff, Middle East conflict, all set against a backdrop of debt-induced low growth - economies sustained, zombie-like, only by ever larger bouts of quantitative easing.


Into this apparently serene world flew a strange, rare, bird - the black swan. The original notion of the black swan, propounded by the philosopher Karl Popper, was based on the idea that if someone saw that all the swans on a particular village pond were white, they would have a good working hypothesis that all swans were white. This would be reinforced by visiting the next village etc.

The trouble is that searching for more white swans can never prove that all swans are white, while the sighting of a single black swan disproves the hypothesis completely.

The key lesson for investors is that "anomalies matter".

During the great moderation, searching for black swans was not a popular pastime and few wanted to hear about the anomalies, or the emerging risks. The credit crunch ushered in a different zeitgeist. Today, the only things worth analysing appear to be "fat-tailed events", and only potential black swans get attention. Everyone is seeking the next black swan, and the more people search for them the more they spot.

Unlike the villagers in Popper's narrative, we now appear to inhabit a world where all the swans on our local pond are black. Our Facebook friends tell us of the black swans in their village, and Twitter is abuzz with stories of the black swans that inhabit the ponds of the eurozone, US and Asia. Increasingly, the majority of investors appear convinced that all swans are black.

While this phenomenon may be real, and the proportion of black swans really may have increased, it could just be that this apparent rise in black swans is one of perception.

In his book Thinking, Fast and Slow, the psychologist Daniel Kahneman explains how our minds subconsciously overestimate the probabilities of unlikely events and compound this by overweighting unlikely events in decision-making. The framing of questions and statements also has a big impact on our perception of probabilities. The mind responds better to vivid stories than to abstract data.

The implications of Mr Kahneman's work for investors' views about black swans are readily apparent.

With so many people searching for them, it is easy to overestimate their numbers. If these risks are framed as something that "could" happen, rather than the probability that they "will" happen, they become more believable. If they are then presented in a strong narrative, our natural tendency is to believe it. Mr Kahneman also warns that frequent repetition encourages affirmation of ideas - regardless of veracity. Thus, those who shout the loudest and most often may have the largest followings on their blogs or appear more frequently on TV. They will probably have their views accepted.

Investors need to be aware that just because the consensus is repeated loud and often it need not necessarily be true. Investors would do well, as Mr Kahneman advises, to overcome the "urges of intuition" and focus instead on time-consuming, detailed analysis - anchoring their views in the "base rate probabilities" of events instead of believing that "this time is different". In the post-credit-crunch new order, many investors perceive that few reliable macro-to-market relationships survive. These "white swans" are now the anomalies.

David Fuller's view There is wisdom in these comments and I recommend that you read the full article by Ian Harnett.

Experienced investors will have observed that in a lengthy bull trend many people lose the ability to identify risk. They become complacent and rationalise higher valuations as evidence that risks have been reduced by a combination of our superior skills (sic) and technology.

However, following a burst bubble as we saw in 2000, and then a further meltdown in 2008 as additional excesses were exposed, the collective mood ranges from cautious to extremely bearish, despite far more realistic valuations and dividend yields that are, on average, considerably higher than in the last secular bull market's later years.

Sure, there are plenty of economic and financial problems, often of an ever changing nature. I am tempted to reply: 'And thus it always was.'

The creation of market bubbles masks our perceptions of risk. Similarly, the return to more attractive valuations that we have seen in recent years often heightens our perception of risk.

Yes, our standard of living may have deteriorated in recent years, particularly in the west. However, stock market valuations have improved and we should not lose sight of this.

There is one additional factor that has intensified our perception of risk, which I have mentioned frequently in recent years. It is high-frequency trading (HFT) which often accounts for over half of our daily volume on major exchanges. HFT is largely responsible for the 'risk-on' and 'risk-off' banality. It leads to slow motion melt-ups and somewhat larger and faster melt-downs than we have seen on average in earlier years. You can see the evidence on this 10-year chart of the S&P 500 Index.

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