One of the great myths of investment is that success is in some way predicated on being able to predict the future. While it is seldom expressed in these terms, this belief is nevertheless endemic in the professional investment industry.
How to avoid whipsaw? Focus on the long term
Perhaps the most dangerous of the investment soothsayers is the over-confident market commentator who makes bold, short-term macro-economic and market predications with the oratorical skill of an Old Testament prophet and the success rate of an English opening batsman.
Although such forecasters cause limited damage to investor returns in calm market conditions, they are especially dangerous during periods of market turmoil, as they tend to be conduits for the ‘whip-saw’ phenomenon. This blight on investors typically occurs when investors make fast, over-confident decisions in difficult market conditions and often leads to a permanent loss of capital.
When Markets Move Fast, Fools Rush In
The mechanism of the ‘whipsaw’ will be embarrassingly familiar to many experienced investors. The process typically starts with a significant change in the price of an asset and concern among investors. The void created by actual knowledge provides the perfect opening for commentators to make confident predictions about the near term price movements. In most cases these predictions can be likened to a high stakes coin-toss with other people’s capital wagered on the outcome.
Approximately half the time prices will do the opposite of that predicted. This incurs sudden paper losses for the investor who has followed the forecaster. Having suffered further falls, the investor commonly loses confidence in the position – or the forecaster will change their narrative – and consequently the position is closed and the losses are crystallised.
A recent example would be investors who bought sterling on the back of the predictions ahead of the Brexit referendum only to reduce this position at a lower price in the panic that accompanied the ‘leave’ result. Those investors who subsequently increased their sterling position as prices stabilised at a higher level realised a permanent loss of capital.
Why are Investors Taken In?
Given the known dangers of being whipsawed, it is reasonable to ask why experienced investors follow the siren song of over-confident forecasters. The most likely answer is that the forecaster appeals to the natural human preference for action over inaction when faced with uncertainty. This is most commonly described as the ‘fight or flight’ response.
While the rush of adrenalin that accompanies this response is ideally suited to extracting us from dangerous physical situations, it is counter-productive when seeking to estimate the probabilistic outcome of investment choices.
To combat this adrenalin fuelled response, investors need four things: First, clear principles that guide decision making and promote good investment behaviour. Second, an investment process that encourages analysis and challenge over confirmation and activity. Third, humility about the conclusions we reach, especially as they relate to macro-economic conditions, and finally a supportive environment that allows investors to think independently and focus on the long term.
This tension between doing the right thing and following the direction of the majority narrative was best described by Keynes who wrote that it is “better to ‘fail conventionally than succeed unconventionally”. Over confident forecasters are a classic example of the former, we as investment managers and advisers have a responsibility to do the latter.
A version of this article originally appeared in Investment Adviser magazine
