What We Do When Things Go Up (a lot)

Featured / Joe Wiggins

There have been some quite significant moves in asset prices in recent times. The dramatic increase in the price of gold over the past year has probably not escaped your attention, but it is not the rise in the yellow metal that is most interesting to me, rather the behavioural implications. How does extreme positive performance from any asset class or fund make us think and act, and why?

The behavioural drivers

Availability: The availability heuristic exerts a huge influence. This is the mental shortcut where we judge something not based on the weight of evidence, but by how prominent and frequent it is. When an asset class keeps hitting new highs, we conflate the volume of ‘evidence’ with its strength. There might be lots of articles, but if they are all saying the same thing, they are far from independent reasons for us to believe the performance will continue. In these situations, availability also leads us to understate risks – because we are not seeing the downside risks, we are likely to severely neglect them.

Stories: Humans understand the world through stories, and when an asset class is on an unprecedented run of good performance, plenty of stories will be told. We will treat these stories not just as explanations as to why something has occurred, but as a prediction of its persistence. We are inherently uncomfortable with things happening without a clear explanation, so to escape this dissonance we look for convincing explanations so that the world makes sense.

Extrapolation: The combination of high-profile performance and persuasive stories inevitably leads to extrapolation – the trenchant belief that what has been happening will persist into the future. The stronger and more sustained the high returns of an asset class, the more we struggle to see anything to stop it.

Fear of Missing Out: We are relative creatures. Our feelings about most things are framed by how it compares to something else (often other people). Two things happen in this regard when an asset is producing strong, high-profile performance. Those of us that don’t have exposure to the asset class will envy those that do, and those of us that do will wish they held more.

Feedback loops

This combination of behavioural factors creates powerful self-reinforcing feedback loops that can serve to further boost an asset’s performance. It works something like this:

Stage One: High returns from an asset class receive significant attention.

Stage Two: Stories are formed to explain the performance; these stories are prominent and convincing because performance is strong.

Stage Three: The combination of high returns and compelling justifications increase the belief that the trends will persist.

Stage Four: More investors are drawn into the asset class.

Stage Five: Returns are boosted by increasing investor appetite.

And so it goes on, until it doesn’t.

These feedback loops are driven by changes in investor behaviour and sentiment, and impact all asset classes over the short-run. For assets that generate cash flows, over time the phenomenon will be outweighed by the gravitational pull of valuations and fundamentals (at some point someone might say “maybe 100x earnings is a little too rich”). This doesn’t occur for ‘belief assets‘ that are not tethered to fundamentals (such as gold or crypto), which makes the range of potential outcomes incredibly wide.

Thresholds

Another fascinating aspect of what happens when the price of an asset rises substantially is at what point do different types of investors become involved (and when might they withdraw). This is clearly a complex topic, but the best model probably comes from Sociology and the work of Mark Granovetter. He explored the subject of crowd psychology and, in particular, how people in a group will have different thresholds for engaging in collective action.

For example, in a group of protestors, there might be some individuals who have an incredibly low threshold for engaging in disorder, whereas others have an incredibly high threshold. Those in the latter group won’t start throwing bricks until almost everybody else has. Granovetter’s argument is that the composition of a group and how behaviour cascades through it will be critical to how it acts.

In a financial market context, we have a huge group of potential investors all with different thresholds for participating in the ascent of an asset class. Day traders, momentum traders, macro hedge funds, all the way to long-term valuation-driven investors. The first group have a very low threshold for engagement, whereas the latter group might only invest when the pressure not to becomes too great (perhaps their job depends on it). The longer strong performance persists, the greater the chance that those high-threshold investors get drawn in.

This threshold model also matters for the reversal of extremely strong performance trends – the key question becoming the reverse: what is the threshold for investors to exit an asset class if returns start to deteriorate? This is what is typically meant when people talk of the dangers of speculative or ‘tourist’ money. Money with a low threshold for exit can create sharp and severe downside risks.

Although the overarching behavioural patterns of investors are similar, their motivations and strategies will be different, and that matters.

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Extremely positive performance from an asset class can be caused by and encourage extreme behaviour. The more prominent the unusually high returns are, the more important it is to reflect on what might be driving our own decision making.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Trying to Time the Market is Like Playing ‘The Traitors’

Featured / Joe Wiggins

Until recently I was seemingly one of the few people who hadn’t seen the TV show ‘The Traitors’.  It became popular so quickly that my stubborn, contrarian streak prevented me from indulging. After some persistent persuasion from my children, however, I succumbed and have been watching the latest UK ‘celebrity’ version. Not only do I have to reluctantly admit to enjoying it, but I have found the contestants’ – often baffling – approach to the game starkly reminiscent of some of the most destructive investor behaviours.

For the uninitiated, the game is very simple. A group of (20 or so) people are put together and a small subset (usually 3) of them are secretly selected to be ‘traitors’. Each day the traitors covertly select one of the ‘faithfuls’ to ‘murder’ (remove from the game). Also, each day, the entire group have to discuss and vote to banish a member of the group who they suspect of being a traitor. For the faithfuls the aim is to rid the group of traitors, while for the traitors it is to remain undetected until the end and claim a prize for themselves. (Party game fans may recognise this structure from Mafia / Werewolf).

A distinctive feature of the game is the almost complete absence of useful evidence the players can use to guess who might be a traitor in the group. The traitors are selected by the producers prior to the show, and players must make judgements based on their interactions with each other during the game. 

The way players decide on who to banish for being a suspected traitor follows a consistent blueprint:

– There is virtually no meaningful evidence about who is a traitor.

– All players significantly overstate their skill in ‘reading’ people and hugely overweight meaningless information. 

– Players construct persuasive, compelling and entirely spurious reasons about why another participant is a traitor.

– The players who put together the most elaborate arguments are considered smart even though they are consistently wrong.

– The player identified as a traitor is banished and it transpires that they were a faithful.

– Players lament their approach and consider whether a different strategy might be worth considering next time.

– In the following round they do precisely the same thing, seemingly forgetting it didn’t work before.

These are all very human behaviours and almost identical to those that we see from investors attempting to predict the short-term movements of financial markets.

The hallmarks of which are:

– An environment defined by noise and very few signals.

– Massive levels of individual overconfidence in the skill to make predictions about asset class performance.

– A wonderful ability to create impressive and coherent stories about market conditions.

– Credibility and airtime given to investors who sound smart.  

– Those investors frequently being wrong.

– Everyone carrying on doing the same thing anyway without acknowledging it didn’t work before.

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Whether we are trying to guess who the traitor is in a party game or predict the performance of US equities over the next 6 months, the patterns will be familiar. We will inevitably see evidence where there is none, be wildly overoptimistic about our own capabilities, and create stories to alleviate the discomfort of randomness and uncertainty.

Human behaviour doesn’t change much, just the context. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Gold is the Ultimate Belief Asset

Featured / Joe Wiggins / 2 Comments

Although it could have easily escaped your attention, as it has received such little fanfare, the price of gold has been rising sharply – recently surpassing $4,000 per ounce. Significant moves in the gold price are fascinating from a behavioural perspective because gold is probably the perfect belief asset – that is an asset which is impossible to value in any reasonable way so it’s worth is entirely dependent on what we think other people believe it to be. This has significant implications for how gold might behave, and how people both talk about it and trade it. 

We are currently in the stage of the cycle where many people conjure up reasons for why gold is so attractive because they cannot admit that they mainly like it because its price has gone up a lot. That is not to say that there are not valid reasons why an investor might hold the asset but, as usual, near term performance must bear much of the responsibility.

How should investors think about gold?

Gold is not a better form of money: One of the most common and vociferous arguments from investors who are bullish on the prospects for gold is that it is far superior to standard fiat currencies because it holds its value, whereas the like of the US dollar or sterling lose their purchasing power through time. This view makes very little sense. In a well-functioning and growing economy, a positive level of inflation is desired – it encourages spending and investment – this means currencies should lose value through time. It is a feature not a bug. Yes, a dollar today may buy you less than it did 30 years ago, but I am pretty sure that salaries have changed over that time also, and I am confident people do things with their money – like spend it and invest it.

The merits of owning gold change depend on what question you ask. Is holding gold over the long-term better than putting cash under the mattress? Quite possibly. Is holding gold over the long-term a better option than owning productive, real economic assets (such as company shares)? I am not so sure.

Gold has excellent Lindy properties: Although the ‘debasement’ argument often made about gold is an exceptionally dubious one, gold does benefit from the Lindy effect. This is the idea that the expected life of something that is non-perishable is proportional to its current age. In simple terms this means that the longer something has existed, the longer we assume it will last. (The expected future life of Great Expectations is significantly longer than anything published last week). The concept is named after Lindy’s deli in New York City where it was speculated that a show running for a month on Broadway could be expected to last for another month.

Gold has been used as a store of value for thousands of years. People have believed in it for an extremely long time, which should give us some confidence that people will keep believing in it. This feels somewhat amorphous – but when you don’t have much else to go on it matters.

Belief assets can be extremely volatile: The more assets are based on belief than anything tangible the riskier they are likely to be. Why is this? If an asset is driven by strong fundamental features – let’s say a high-quality bond with a contractual return and fixed maturity – the range of potential outcomes is very narrow. The more speculative the asset, the more it is based on indefinable beliefs, the wider the range of outcomes and the greater the uncertainty.*

Assets that have long-term, fundamental value drivers experience a (sometimes light) gravitational pull towards some form of fair value. As belief assets have no fair value the price can vary widely – this can be both incredibly lucrative and, at times, painful. (Belief assets are perfect for bubble formation – there is nothing to hold them back).

Prices for belief assets change because perceptions change. If the gold price were to drop to $2,000 is it more or less attractive than it is now? Nothing will have changed about the yellow metal, just what people believe other people believe about it.  

Price moves in gold create stories about gold: As we are being bombarded with stories around the reasons for the rise in gold price – debasement, fiscal largesse, central bank purchases, political uncertainty – it pays to remember the causality here. Price moves come first and then the narratives to justify it second. It is not that the stories have no validity, it is just that they become more persuasive the higher the price rises, creating a self-reinforcing loop – for a time at least.   

Do you like the asset or its trend?  Momentum investing has a long and storied history of delivering positive returns – but only if carried out in a deliberate and measured fashion. One of the problems with strongly trending belief assets is that rather than acknowledge that they want to participate in the price momentum, investors need to offer a compelling fundamental rationale. Although this might make them sound smarter, all it means is that they are a closet momentum investor without the discipline required to do it well.

Know why you own it: Perhaps the key for any investor owning gold is to be very clear about why you hold it, otherwise you risk being whipsawed around as price trends (and beliefs) fluctuate. If you purchase it tactically be specific about the precise factors that are informing your view (even if it is just trend following). If it is a structural portfolio holding you should be willing to bear periods of significant losses with equanimity and understand the exact role it is playing.  

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There is nothing inherently wrong with holding gold, but it is important to accept the type of asset it is and the investment behaviour it may encourage. If Ben Graham had been asked about gold, he may have said something like:

In the short-run, the market (for gold) is a voting machine, and in the long-run it is also a voting machine.

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* Whether an asset is a belief asset or a fundamental asset can also depend on time horizon. An equity investor trading on a three-month view is turning stocks into a belief asset because they are worried only about sentiment (belief) changes – the fundamentals are largely irrelevant.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Good for Who?

Featured / Joe Wiggins / 3 Comments

It seems a fair bet that in a few years’ time we will come to see the two most dangerous words in investing as “democratisation” and “innovation”. Although one might feel like something of a luddite when criticising progress, it is difficult to escape the notion that too many ‘solutions’ in investing are designed to solve the problems faced by the industry, rather than the clients it serves.

New markets, new instruments, new platforms and new structures. It is wonderful to see such a bewildering array of choice available to all. Who doesn’t want to trade single stock options at three o’clock in the morning?

The idea that providing everyone access to everything will provide clear client benefits is a dubious conceit. In most cases all it is doing is creating greater confusion, temptation and cost, while making it increasingly difficult for investors to manage their behaviour.

It is frustrating that minimal thought seems to go into answering the question: how is this development likely to impact client outcomes once we account for the behavioural impact?

There is a seemingly accepted view that opening access to ‘institutional’ assets and instruments previously unavailable to the retail market an undoubted positive. As if most private investors are being shut out from exclusive areas of the market that could transform their fortunes. This exact argument was made about hedge funds years ago, and I am not sure that it worked out too well.

For an industry perspective there are certain things that are critical from a revenue perspective – activity, complexity and differentiation. Unfortunately, these things are all too often a drag on client returns – not many investors who trade a lot, own complex products and struggle to deal with too much choice ever come out well from it.  

There is certainly nothing wrong with innovation, but we must accept that there can be an acute friction between what might be good for industry outcomes and what might be good for client outcomes.

Of course, it is possible to have industry developments that are beneficial for both clients and companies, but the more something egregiously benefits the seller, the more scrutiny we should place on the question – which client problem is this solving?

When shiny new things are brought to market (particularly the retail market) far too little effort is given to making the case as to why clients will benefit. In a world of rapid technological change and declining industry margins, investors will need to be on guard that what is presented as progress, isn’t actually likely to make them worse off.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

What Happened in Financial Markets in the Second Quarter of 2019?

Featured / Joe Wiggins / 1 Comment

I have no idea what happened in financial markets in the second quarter of 2019. I think it is safe to assume that not many people do. The problem is that when we were living through it, it would have felt like the most important thing. As if the ‘information’ we were engaging with would have a profound impact on our investment outcomes. Yet now we cannot even remember it. Our obsession with dealing with what is right in front of us may well be an effective evolutionary adaption, but it is a terrible affliction for most investors with long-term goals.  

Human attention tends to be drawn towards two things – salience and availability. Salience is where something is particularly noticeable (often due to some emotional resonance), and availability is how easily something comes to mind (typically because it is recent). The lure of the day-to-day gyrations of financial markets is strong.

Unfortunately, it is not only an issue of attention, but importance. We are prone to hugely overweight the relevance of what is happening in the moment, as Daniel Kahneman noted:

“Nothing in life is as important as you think it is, while you are thinking about it.”

In the general sense this is not irrational human behaviour. If something is happening or changing in the current instant, then it can make absolute sense to focus on it and deal with it immediately. Taking the time to accurately calculate the probability of whether that movement you spotted on the savannah is actually the head of a lion is probably not a smart strategy. The issue is that rationality is context dependent. What is good for human survival is often terrible for long-term investing.

The problems that stem from this behavioural wiring are twofold. First, we are likely to neglect information that is genuinely important in favour of what we are currently experiencing. Second, we are almost certain to trade too much as we get stuck in the cycle of continually reacting to the next set of salient and available information, or what we might instead call the prevailing market narrative.

That most investors are caught in this behaviourally satisfying but return-eroding loop is reflected in the lack of introspection or reflection around past decisions and opinions. Nobody looks back at all the predictions that were made in our market outlooks for 2019 because it would be embarrassing to acknowledge how wrong we were and how attentively we focused on matters that were either irrelevant or unpredictable. It is better for everyone if we all just keep looking forward.

Escaping this damaging obsession with the present is not simply about overcoming our own behavioural limitations but acting in a manner that is contrary to expectations. It is not just us who feels that we must do something about what is happening right now. Everyone does. Even if we don’t think it is important it makes sense to act as if it is. In this instance taking action is still about survival, but not from the lion, in our job.

There are inevitably periods in time when there are market developments that matter for our long-term prospects. These might be fundamental (such as some significant change in valuations or expected returns) or behavioural (dealing with these challenges of bear markets and bubbles), but will be dramatically outweighed by things that are either unimportant or unforecastable. 

When we are living with markets in each moment it is almost impossible to separate signal from noise because of the undue status we place on the present. Aside from entirely ignoring the vacillations of markets (which for many is impossible), the only conceivable way to deal with this is to define in advance what aspects are important and then attempt to ignore the rest. This is the price of admission for the advantages provided by a long-term investing approach. Nobody said it was easy.

Attempting to be a long-term investor while obsessing over the short-term fluctuations of financial markets is like starting a diet but filling your kitchen with chocolates and cakes; you might still achieve your goals but you are really making it hard for yourself. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

The Paradox of Past Performance

Featured / Joe Wiggins / 20 Comments

Although we may not like to admit it, the past performance of an asset class or fund is likely to have an overwhelming influence on our decision making.  We may try and mask the hold it has on us, but we are inescapably drawn towards investments with strong recent returns. The more pronounced and persistent the outperformance, the greater the pull. There is probably no more prevalent nor puzzling paradox in investing – in order to enhance our returns we make decisions based on a measure that is likely to reduce them.

The past performance of an asset are returns that we are not going to enjoy. They have been (at best) drawn forward from the future – the better the performance before we invest, the worse they will be after. Unusually strong returns are typically the result of unsustainable tailwinds, random doses of good luck and the inescapable swings of market sentiment.

Periods of abnormally strong performance mean that an investment has become more expensive and that it has earned higher returns than it is reasonable to expect on average. Both factors acting as a gravitational pull towards future disappointment.

This type of behaviour is most pronounced in active fund selection. Here it is not even an implicit driver of decision making, but rather an explicit feature of most processes. The popularity of star fund managers is (at least in part) forged on the notion that exceptional returns in the past are a prelude to exceptional returns in the future. We ignore the realities of valuations, the spectre of mean reversion, and fickle hand of fortune, and instead assume that some form of idiosyncratic skill will overcome all of these factors. This is an assumption with terrible odds of success.

The pull of past performance is not unique to fund manager selection, it is pervasive across the industry. We only need to look at the clamour for US equities following a decade (or more) of stellar performance. Investors seem to behave as if the market’s outsized returns in the recent past increase the probability of a continuation of this pattern, when in all likelihood the reverse should be true.

Why do we have such a strong tendency to read the wrong signal from past performance?

Extrapolation: We seemingly cannot avoid believing that trends of the recent past will persist, even when this view seems to be contrary to any rational analysis. A critical part of this anomalous behaviour is the power of storytelling. When assets or funds deliver exceptionally strong (or weak) performance, narratives are weaved to explain them. These compelling stories that justify unusual returns also bolster our belief that they will endure.  

Outcome Bias: Aside from our inescapable short-termism (more on that later), outcome bias is probably the most damaging behavioural foible suffered by investors. Whether it be for a stock, fund or asset class, when we witness strong performance we imbue that thing with some inherent goodness (and vice-versa). High past returns give us increasing confidence in the credentials of an investment. It must be good, haven’t you seen the returns?

Career Risk: For many, being in thrall to past performance is a survival strategy. Most professional investors make decisions to survive over the short-term. Although performance chasing might objectively appear to be an odd strategy at an aggregate level, for an individual it might be the best way to keep our job or avoid another difficult meeting. Investing in the in-vogue areas of the market can be both irrational and rational at the same time – it depends on our objective / incentive.

Instant / Delayed Gratification: Inherent in the paradoxical impact that past performance has on our decision making is the trade-off between instant and delayed gratification. We have an ingrained preference for doing things that make us feel better in the moment over waiting for rewards that may occur at some uncertain future point. Performance chasing gives us an instantaneous, positive hit – we are investing in areas of the market that are working right now, the stories supporting it are captivating and everyone thinks we are making a sensible call. The alternative approach gives us pain now with any benefit someway off in the distance.

One clear signal of the dangers innate in performance chasing is that there is no behavioural cost. It is easy to do and feels good when we do it. Almost all positive investment approaches come with behavioural pain – something has to hurt.

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There is one important exception about the perils of making decisions based on past performance. The success of trend-following strategies, which are explicitly past performance focused. If there is evidence of this working, why is performance chasing such a problem? There is a critical distinction. The success of systematic trend-following strategies is about the consistent application of discipline and rules. Conversely, most investors engage in erratic trend-based investing (we invest in things because they have ‘gone up’) and rationalise the decision based on some post-hoc fundamental analysis.

We are largely secret trend-following investors not admitting how much past performance matters to ourselves or others, and absent the aspects that makes capturing such trends work. 

The paradox inherent in investors’ unhealthy focus on past performance does not mean that we should scour the market for the most egregious laggards, but rather be wary of the influence of high historic returns on our decisions and realistic about its likely consequences. Unusually strong past performance should make us concerned not confident. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Does Increasing Geopolitical Risk Lead to Higher Equity Market Returns?

/ Joe Wiggins

It is hard to argue against the idea that geopolitical tensions are rising, and this type of backdrop can be incredibly difficult to navigate for investors. When the news is filled with discussions of war and conflict, it is natural to lose sight of our long-term investment objectives, and instead become focused on short-term, financial market worries. Yet, contrary to how these environments are likely to make us feel, a 2024 study showed that future equity market returns tend to be higher when coverage of war is more prominent in the media.

In a paper titled: “War Discourse and Disaster Premium: 160 Years of Evidence from the Stock Market“, a group of academics analysed 7 million New York Times articles spanning nearly 160 years and identified how much coverage was dedicated to a set of specific topics each month. They then linked the strength of this coverage to subsequent equity market returns from periods of one month to 36 months.

They found that of the topics considered, ‘war’ was the strongest predictor. Between 1871 and 2019, a 1 standard deviation increase in the intensity of war coverage in the New York Times predicts a 3.8% increase in annualised monthly returns. Over three years, the same rise in war coverage predicts 2.3% higher returns over the next 36 months.

In simple terms, the more that war was a focus of the articles in the New York Times, the higher subsequent returns were all the way up to three years out.

Why might war be good for equity market returns?

Although these results run counter to our behavioural instincts – not many of us treat war or rising geopolitical risk as a buy signal – that is probably the exact reason why this relationship appears to exist. For me, there are two plausible explanations for the phenomenon described in the paper:

  • Heightened coverage of war and geopolitical risk leads investors to overstate the potential impact on financial markets and unduly mark down equity prices. This leads to lower valuations and higher future returns.
  • Increased war coverage is an indicator of rising risk of economic and market catastrophe (what we might call disaster risk) and therefore equities are prudently priced lower. The expected return is greater because risks are also now more pronounced.

We can think of these explanations as being irrational (in the first case) and rational (in the second case). The consequences of both are the same – higher expected returns because equity markets have sold off and valuations are lower. In truth, both factors are probably at play.

Does geopolitical risk create buying opportunities?

Not so fast. There are some significant limitations with the study.

The first is the spectre of survivorship bias. While the data may show that future equity market returns rise alongside war coverage because investors overstate the risk of economic disaster, this is only true because there has been no such catastrophe. The world has to survive for us to see the results – so we cannot easily tell whether a pricing anomaly actually exists.

Equity market returns are predicted to be higher following periods of increased war coverage, provided the world doesn’t end!

(It may be reasonable to argue that if the world does end, we won’t be that worried about the returns from our equity portfolio).

The paper also does not advocate investing in specific countries that are the focus of increased geopolitical risks. It deliberately looks at general coverage of war and its impact on US equity markets. If instead it observed the impact on equity market returns of a country directly involved in a conflict, the results might be somewhat different.

Don’t compound geopolitical risks

The authors refer to the results of their study as a ‘war return premium’, which suggests it is something to exploit and potentially benefit from. However, I would frame the findings somewhat differently. When risks are prominent and emotive, we are liable to allow them to overwhelm our judgement, and prone to overstate the likelihood of worst case scenarios. We should guard against this.

If a ‘war return premium’ exists, it does so because of how investors react to the increased intensity of war coverage in the media. I think we should be less concerned about collecting the premium and more focused on not being the investor who pays it by making poor decisions in stressed geopolitical environments. The evidence suggests that our instincts during such times are likely to serve us poorly.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

How Does AI Think Markets Will Perform in 2026?

/ Joe Wiggins

In 2025, I ran a prediction game for finance professionals. This year, to keep pace with current trends, I decided instead to pose ten questions about markets in 2026 to several AI large language models (LLMs). Will they do any better than humans, and will they agree with each other?

I used three AI LLMs for this task: ChatGPT (5.2), Gemini (3), and Claude (Sonnet 4.5). Here are the questions and responses:

1) Where will the S&P 500 finish 2026?
ChatGPT: 7,700
Gemini: 7,555
Claude: 6,800

2) Where will the FTSE 100 finish 2026?
ChatGPT: 10,600
Gemini: 10,750
Claude: 9,200

3) What will the ten-year Treasury yield be at the end of 2026?
ChatGPT: 4.5%
Gemini: 3.75%
Claude: 4.50%

4) Where will the GBP/USD spot rate be at the end of 2026?
ChatGPT: 1.28
Gemini: 1.38
Claude: 1.28

5) What will the dollar price of Brent crude oil be at the end of 2026?
ChatGPT: $57
Gemini: $55
Claude: $66

6) Will there be a 20% decline in the S&P 500 in 2026?
ChatGPT: No
Gemini: No
Claude: No

7) What will the dollar price of Bitcoin be at the end of 2026?
ChatGPT: $130,000
Gemini: $135,000
Claude: $78,000

8) Will the Russell 2000 outperform the S&P 500 in 2026?
ChatGPT: No
Gemini: No
Claude: No

9) What will the Federal Funds Target Rate (upper bound) be at the end of 2026?
ChatGPT: 3.25%
Gemini: 3.25%
Claude: 3.50%

10) What will the dollar price of gold be at the end of 2026?
ChatGPT: $4,500
Gemini: $4,900
Claude: $3,100

It was reassuring that when I initially asked the AI models to make these predictions, they were reluctant and would only offer heavily caveated ranges – suggesting they may be better calibrated than humans. I had to persuade them to produce point forecasts!

Of course, the models were right to be reticent. No LLM will be capable of making accurate and specific predictions about a system as complex as financial markets. Still, there were some other aspects I wanted to explore.

Were the predictions consistent across models?

Absolutely not. While there was some consistency between ChatGPT and Gemini, Claude made several very bold calls (gold at $3,100, for example). Interestingly, Claude’s rationale was often the most “convincing.” It behaved like a particular type of market strategist – frequently wrong, but articulate and provocative – and therefore attracting the most attention.

Were the predictions internally consistent?

This is an important and difficult question to answer. The models could certainly sound internally consistent when asked to justify their views, but some combinations looked odd. For example, Claude was the most bullish on oil while also being the most bearish on UK equities – a scenario that could happen, but feels like an unlikely pairing (given the resource heavy nature of the UK market).

Are they better than human predictions?

I was asking the models to predict outcomes that, in my view, are impossible for either humans or LLMs to forecast with any real accuracy. Can they do this as well as a human? Almost certainly. Does that make it useful? Outside of marketing copy, probably not.

There are definitely more important things to spend tokens on!

—

* Thank you to my colleague Duncan for suggesting this post.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

What Does ‘The Traitors’ Teach Us About How We Invest? Part II

/ Joe Wiggins

Having already written a piece on the similarities between how contestants in the TV game show The Traitors behave and our futile attempts to time financial markets, I thought I was finished with the subject. After indulging in the fourth UK series of the show, however, I realised there are so many excellent examples of human folly and perplexing decision-making that it felt worthy of a sequel.

For those uninitiated, there is a recap of how the game works in my previous post on this subject.

Here are some traitorous observations on investor behaviour:

We like being part of the herd. In the first banishment round of the latest UK series, 16 of the 21 contestants voted to remove the same person from the game. This broad consensus was reached despite there being no meaningful evidence to speak of. Of course, despite the agreement, they were entirely wrong.

We don’t like outsiders. After the first failed banishment, one of the 16 people who voted to remove a Faithful suggested turning their attention to a contestant who had voted differently, on the basis that this made them a potential Traitor. This was despite the majority having been incorrect in their prior accusation. It does not matter whether a group is right or wrong; it is safer to be in it.

We have a narrow circle of competence. A consistent feature of the game is that people in certain professions, such as lawyers and police detectives, believe they will be good at it and are reassuringly terrible. Part of me worries that people whose jobs involve making decisions under uncertainty do not seem to spend much time thinking about how to make good decisions. Another part simply concludes that our circle of competence is far narrower than we like to admit.

We are wildly overconfident. Along similar lines, a highlight of the most recent series is a retired police detective who plays the game with great confidence while aggressively and incorrectly accusing the wrong people of being Traitors. They also decided to keep their previous career a secret from the group, until revealing it to one other contestant who was, with wonderful inevitability, a Traitor. We are not as good as we think we are.

We are in thrall to expertise. Even though participants with so-called decision-making backgrounds are wrong at least as often as everyone else, other contestants remain in awe of their supposed expertise, no matter how often it proves unreliable. This is reminiscent of investors patiently waiting for the next insight from a market strategist who is right about as often as a coin flip.

We are attracted to new things. In the game, a banishment occurs every episode or day, and there is a strange behaviour whereby one day an individual may attract a great deal of suspicion and votes, but if they survive, they are barely mentioned the following day. We are drawn to shiny new things even when the evidence has not changed at all, much like investors latching on to the topic of the month and forgetting what they were previously obsessed with.

We are terribly calibrated. One of the most enjoyable and bewildering facets of the game is how often contestants say things like, “I am 100 percent sure X is a Faithful.” This is typically based on no evidence whatsoever and would be absurd even in situations where we have good reason to be confident. Here, participants have almost nothing to go on. We are very poor judges of how confident we should be about uncertain outcomes.

We need to survive: Although the game is focused on identifying Traitors in the group this isn’t really very important until we get near to its end because banished Traitors are replaced anyway. Participants shouldn’t care that much whether they banish a Faithful or a Traitor – they just need to make sure it is not them. Survival is the most vital and underappreciated thing in both the game and investing.

We cannot read people. Whether it is identifying a Traitor or judging a fund manager, we are awful at reading people yet remain convinced we are good at assessing both honesty and intentions. In a previous season, there was a contestant who was a professional magician whose job involved reading people. He was predictably hopeless at the game.

We ignore the most important things. Given how little useful evidence there is for identifying Traitors, particularly early in the game, the most sensible approach outside of choosing someone at random would be to ask: if I were a producer of this show, who would I select as a Traitor? Either contestants do not think this way, or, if they do, it is not shown on television because it would spoil the magic. My guess is the former.

We use salience as evidence. Judgements about who is a Traitor, especially early on, seem to be driven by what or who is salient, noticeable, or different. We mistake what captures our attention for what is meaningful. The current UK series has seen players frequently banished after making themselves the centre of attention – which is baffling behaviour.

While The Traitors is a light-hearted and convoluted game, it does a great job of revealing some of our most ingrained and peculiar behaviours. When we watch it and feel frustrated by the decisions being made, it is worth remembering that the contestants are simply being human. We do many of the same things in life and certainly when investing.

—-

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Killing the Goose that Lays the Golden Egg

/ Joe Wiggins

From a behavioural perspective, our ability to meet our long-term investment objectives is really about one thing: managing the conflict between our desire to save for the future and our craving to make ourselves feel better in the present. This has always been an incredibly exacting challenge, but it is being exacerbated by an industry that seems set on innovations aimed at exploiting our weakness for immediate satisfaction.

Back in 1997, economist David Laibson published a paper titled “Golden Eggs and Hyperbolic Discounting”. In it he contends that our long-run savings and investment goals are frequently compromised by the behaviour of our present-biased selves.

There are two key elements to this:

  • We fail to save sufficiently for the future because we choose to consume more today.

  • We fail to keep our savings invested for the long run because of our response to short-term volatility and temporary market losses.

Laibson argues that investors are therefore blighted by having “too much” liquidity, which gives us ample opportunity to prioritise how we feel right now over our future needs. If we know that humans have this strong tendency, then illiquidity becomes incredibly valuable – because it protects us from ourselves.

While Laibson refers to the value of illiquidity, he is not advocating a wholesale switch into private markets. What he means is the use of commitment devices: steps we can take to prevent panic selling or otherwise stop us reacting in-the-moment at the expense of our future needs.

Commitments come in many forms – the most obvious being investment vehicles holding genuinely illiquid assets with lock-up periods. Not everything has to be so punitive, however. Soft frictions, such as auto-enrolment or the Save More Tomorrow scheme in the US, can also be extremely effective. Anything that reduces impulsive behaviour can deliver value many years from now.

While tools that encourage commitment can have a dramatic impact on behaviour, there is a problem: we don’t like being asked to commit. There are several reasons for this:

  • It feels like a restriction of choice and agency. Adding friction to slow our decision making or reducing our ability to act can feel like a loss of freedom. Imagine if an investment platform introduced a 24-hour “cooling-off” period for every trade. This would likely be effective at limiting hot-state behaviour, but few people would choose to use it.

  • We don’t think we need them. Commitment devices are designed to counter problems caused by our present-biased selves. To value them, we must first accept that we suffer from this behavioural failing. Of course, we all do – but we are far more likely to see it in others than in ourselves.

  • Commitment devices involve trade-offs. Anything that reduces liquidity or limits action for the benefit of our future self comes with a present-day cost. This may not just be frustration at our inability to act; it could also mean being unable to access funds when they are genuinely needed.

Laibson made the argument about the dangers of “too much liquidity” nearly 30 years ago, but his case feels more relevant – and more urgent – than ever. Humans remain inescapably present-biased, yet the investment landscape has evolved in ways that exacerbate (and perhaps deliberately exploit) this bias, to the detriment of our long-term savings goals. There are a host of contributing factors, but these are the most culpable:

  • ‘24 hour’ trading. Financial markets are increasingly ‘always open’, providing instant liquidity at all times. There is no restriction on our ability to react in the moment. This can be framed as technology-driven liberation or, more realistically, as a behavioural disaster.

  • Constant portfolio access. Not only can we trade at any time, but we can live the minute-by-minute fluctuations in our portfolio values. Nobody would argue that investors should not have access to this information, but few have seriously considered the behavioural cost.

  • More news and emotional stimulus. We are bombarded by financial news and opinion, a phenomenon greatly amplified by social media. There is more news, more noise, and more negativity. Humans make poor decisions when emotional stimulus is high and friction is low – precisely the environment we now inhabit.

  • The financialisation of everything. Over time, more aspects of life are becoming financialised products to buy and sell – stocks, currencies, cryptocurrencies, sports, even political events. Everything has become something to trade. The line between gambling and investing is increasingly blurred, and may soon disappear entirely.

All of these factors increase the likelihood that we sacrifice long-term goals for short-term fulfilment. If Laibson was worried in 1997, he should be petrified today.

We can think of the golden egg as the future consumption funded by our savings, and the goose that lays it as a sensibly diversified investment portfolio. Financial and technological innovation is making it far easier to kill the goose.

—

Laibson, D. (1997). Golden eggs and hyperbolic discounting. The Quarterly Journal of Economics, 112(2), 443-478.

(Laibson frames the ‘golden egg’ in a slightly different way in this paper, but the overarching point is the same).

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

How Good Were Your 2025 Financial Market Forecasts?

/ Joe Wiggins

Back in December of 2024, I ran a survey which was completed by 276 finance professionals. It asked them 10 questions on what would happen in markets in 2025.

Let’s see how they got on:

Question 1 – What will be the % total return of the S&P 500 in 2025?

Prediction: 6.5% (mean)

Outcome: 17.9%

The 21 participants that predicted a loss of 10% or greater for the US market must have been feeling pretty good in April, but by the close of the year the US market had recovered to produce a total return just short of 18%. Of the 268 responses, only 8% predicted performance of 18% or more.

The average return expectation was for a 6.5% total return from US equities in 2025. While this seems a reasonable number such ‘normal’ performance is quite rare in any given calendar year – equity returns are high because they are very lumpy!  


Question 2 – Will the Russell 2000 outperform the S&P 500 in 2025?

Prediction: Yes (60%)

Outcome: No

The respondents were moderately optimistic about a recovery in the fortunes of smaller US companies, perhaps through a combination of depressed (relative) valuations and the initial hopes for the economic impact of Trump’s second term. As it turned out, the performance of small caps in the US was decent in absolute terms, but they still trailed the mega caps by c.6%. Maybe 2026 will be the year.


Question 3 – Which equity market will produce the highest total return in 2025 (USD terms)?

Prediction: US equities (39%) 

Outcome: Chinese equities (20% of respondents)

There was a strong expectation for a continuation of US equity exceptionalism in 2025, which turned out to be entirely wrong. While near 40% of participants backed the US to be the leading market in 2025, its returns trailed all other options except for India. This was a win for the contrarians, as the much-maligned Chinese market came top of the pile – making 20% of the respondents right.  


Question 4: What is the probability of the US economy entering a recession in 2025?

Prediction: 25% chance of a recession (mean)

Outcome: No recession.

Without the ability to observe parallel universes it is quite difficult to judge the quality of responses here. All that can be said is that most participants were generally sanguine about the prospects for a US recession in 2025 and the outcomes were consistent with this. It was looking a little dicey in April and May, however, with prediction markets pricing in a 60% chance in 2025.

Oh, and the 23 forecasts of a 0 or 100% recession probability were wrong from the start.  


Question 5: Will Nvidia outperform the S&P 500 in 2025?

Prediction: No (62%)

Outcome: Yes. Nvidia returned 39%, against 18% for the S&P 500.

Much like the small-cap view, participants were expecting a broadening out of US equity markets in 2025. It seemed reasonable to believe a company of that size, trading on that valuation with that stratospheric performance history couldn’t outperform for another year, but markets have a history of being wholly unreasonable.


Question 6: What will be the GBPUSD spot exchange rate at the close of 2025?

Prediction: 1.26 (mean)

Outcome: 1.34

Although on average there was an expectation for a slightly stronger sterling / weaker dollar across 2025, the most common prediction was for sterling weakness (1.20). This probably reflects lukewarm sentiment for the UK and (thus far) unfounded optimism about Trump’s impact on the dollar. Only 16% of respondents went for a rate of 1.34 or above.

Here is a resolution for 2026 and for every year for all investors – I will not make currency forecasts.  

  
Question 7: What will the USD price of Bitcoin be at the close of 2025?

Prediction: $108,353 (mean), $95,000 (median)

Outcome: $87,647

Participants were a little too optimistic about the fortunes of this ‘belief asset’ in 2025, however, the forecasts did range from $1m to 0 so it was a little noisy. It is hard to say whether any given prediction is either serious or a joke given the nature of the asset.


Question 8: Will the S&P 500 suffer a peak to trough decline of more than 20% in 2025?

Prediction: No (60%)

Outcome: No (just)

Although US equity returns were strong across 2025, there is also a Wikipedia page for the ‘2025 Stock Market Crash’, which although seeming a little dramatic is a reminder of the negativity that surrounded ‘Liberation Day’ and the policy chaos that surrounded it. If we classify a bear market as a 20% decline, the S&P 500 just missed out in 2025 falling 18.9% between 19 February and 8 April.


Question 9: What will be the annual rate of US inflation (CPI) in 2025?

Prediction: 2.9%

Outcome: 2.7% (November print)

This is a tricky one for a couple of reasons: 1) We don’t yet have the December figure, 2) There was much scepticism from economists about the November print because of the impact of the US Government shutdown. It is probably fair to say that the average inflation expectation for 2025 was in the right ballpark.


Question 10: What will the US Ten Year Treasury yield be at the close of 2025?

Prediction: 4.20% (mean)

Outcome: 4.17%

Who said that forecasting bond yields was difficult? The crowd was wise on this topic with the average prediction being pretty much bang on the yield of ten-year Treasuries at the close of 2025. The dispersion of responses to this question was, however, wide. 20% of participants forecast the yield finishing the year above 5% and another 20% below 3.5%. Lots of wrongs can make a right.


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Making good predictions about financial market performance over short periods such as one year is incredibly difficult. In essence, we are trying to forecast how other market participants will react to events that we know will happen but don’t know the outcome and events that we don’t know will happen and (by definition) can’t know the outcome. We also need to work out how these events or developments might interact with each other. It would be hard to design a more complex prediction problem. *

(There is a reason why annual investment outlooks don’t spend much time reviewing what they said a year ago.)

Given this it is somewhat baffling that the entire asset management industry can sometimes feel like a giant forecasting game – one where people are constantly making predictions while being incurably afflicted with amnesia about the quality and content of their previous judgments. I was totally wrong last time, but you have to listen to me this time around.

The good news is that for most investors this is all irrelevant noise. Our long-term investment fortunes will not be defined by our ability to foresee what will happen in markets over the next quarter or year. They may, however, be defined by our ability to accept this and act accordingly.

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* It is not even about getting a single prediction right, you have to do it again and again.

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Why Did You Buy That Stock?

/ Joe Wiggins

When you buy a stock, what drives your decision-making? In a new study, academics ran a series of AI-driven interviews with over 1,500 investors from across the world about their stock-picking choices, and found 13 different factors (or what the paper calls “recurrent mechanisms”) that motivate decisions to invest in a particular company. Although there were some notable distinctions across regions and cultures, Fundamental Strength and Growth / Innovation proved to be far more common reasons than Valuation / Mispricing and Momentum. [i]

The researchers employed AI to conduct field interviews with a large group of investors situated in several countries (including the US, UK, India, and South Korea). There was also a broad spread of investable assets, with 42% of the sample between $1,000 and $499,999, 29% between $500,000 and $999,999, and 29% above $1m.

Participants engaged in open-ended, AI-led conversations designed to explore their rationale for stock purchases. A GPT model was then used to assess the responses and define “recurring decision patterns” or, in simple terms, the reasons why investors were buying stocks.

The process led to the identification of 13 mechanisms that commonly described the choices made by investors around individual company investments. They were ranked as follows:

  1. Fundamental Strength (40.5%)*
  2. Growth Innovation (37.6%)
  3. Familiarity / Brand Effect (28.4%)
  4. Blue Chip Comfort (28.1%)
  5. Authority / Follow (18.6%)
  6. Momentum (17.9%)
  7. Confluence (14.6%)
  8. Dividends (14.0%)
  9. Social Copy (13.6%)
  10. Valuation / Mispricing (13.6%)
  11. Buy the Dip (12.5%)
  12. ESG / Values (10.3%)
  13. Technical Analysis (6.8%)

(The numbers in parentheses show the proportion of responses where a specific mechanism or rationale was identified.)

This is a fascinating study that I would recommend taking the time to read. I have some initial observations on the results:

Investors like to own stocks that are performing well right now:

If you had asked me, prior to reading the study, to predict its findings, I probably would have said that investors like to buy stocks that have good current profitability and positive sentiment around its prospects – consistent with Fundamental Strength. This plays into so many of our behavioural biases – most notably our desire to extrapolate, our focus on recent outcomes, and susceptibility to salient stories. What is more attractive to an investor than a high-profile stock with good recent results and a captivating narrative?

In addition to this result being unsurprising, it is also worrying that so many investors implicitly believe that they have an edge in judging the prospects of these types of companies.

Investors can’t resist a good growth story:

It is also unsurprising that investors have a preference for growth and innovation. While this may be somewhat exaggerated by market conditions in recent years, the desire to invest in innovative companies with the potential for abnormally high payoffs predates the more recent success of technology and AI-related names.

Investors are comfortable with what they know:

Investors like companies that have an established history and those which they may have personal experience with. There are some powerful heuristics at play here, both in the view that a long-established company may be lower risk, and in the tendency for people to judge a company’s prospects by how positive their own experience is with the product or service it offers. I would expect this factor to be far more common among private investors, where the depth and breadth of knowledge of the universe of stocks is very likely to be limited compared to professional investors.

There is good news for value investors:

Value investors will probably have mixed emotions reading this study – both despondent that Valuation / Mispricing does not rank highly among the reasons people buy stocks, and delighted at the opportunities that may arise because valuation does not rank highly. Value investing works (over time) because it is behaviourally difficult, and because we are predisposed to care more about other things (valuation only scores as highly as copying other people).

There is probably a stigma around momentum investing:

Momentum as a standalone factor only ranks sixth, but I think this understates how important recent returns are to investor decision-making. Performance momentum is inevitably deeply intertwined with Fundamental Strength, and I have a strong suspicion that people are likely to justify performance-chasing decisions as being driven by strong fundamentals. It sounds more compelling and robust to say that you have invested because of a company’s improving operational prospects, rather than because its price has gone up a lot recently.

There are significant cultural / regional differences:

There are some fascinating regional and cultural differences in the study. For example, Fundamental Strength is stronger in Japan (60%) than in the US (30%). Also, close to half of the responses in Japan were assessed to have Familiarity / Brand Effect as a meaningful contributor to stock decisions. The extent to which these are entrenched differences or reflective of more recent, localised market performance is
unclear, but it is undoubtedly interesting.

–

Why are certain factors so influential in what stocks investors buy?

If we look through the underlying mechanisms described, there is a heavy behavioural influence on the largest contributors to stock picks – Fundamental Strength (extrapolation, outcome bias), Growth Innovation (lottery-ticket pay-offs, stories), and Brand Effect (familiarity). This seems to outweigh the influence of factors that have somewhat more evidence supporting them (such as Valuation / Mispricing and Momentum).

Of course, it is impossible to know with any level of confidence what drives our behaviour and this study only goes so far as to seek to identify the stated reasons for a stock purchase. This raises two intriguing questions:

– How significant is the gap between the stated reasons and the ‘real’ drivers of our investing behaviour?

– If the stated reasons are a fair reflection of the factors influencing our stock purchasing decisions, why do investors choose those factors? (Why is Fundamental Strength more important to us than Valuation? What is the appeal of dividends?)

Questions for another post.

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* The definition of Fundamental Strength is as follows: “Investors buy stocks when audited financial information indicates robust current performance, which, to investors invoking this mechanism, also signals high expected future returns.” Definitions for each of the mechanisms are provided in the full study.

[i] How Investors Pick Stocks: Global Evidence from 1,540 AI-Driven Field Interviews

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Every Asset Managers’ 2026 Forecasts

/ Joe Wiggins

It is that most wonderful time when asset managers publish their expectations for the coming year, so I have decided to lightly update my 2025 version of what all of these will say:

Here goes:

– There is no AI bubble (2026 special): Nobody is going to tell clients there is an equity market bubble, but the importance of being selective will be emphasised.

– Uncertainty will persist, diversification is critical: This will be framed as being particular to the year ahead, but is always true.

– Investors need to be nimble: This is the asset allocators’ version of ‘a stock picker’s market’.

– Investors need to be discerning: A stock picker’s market.

– The traditional approach to portfolio management might not work anymore: Just in case a reader is investing in an old fashioned, unsophisticated way. Yes, the 60/40 is still dead.

– Economic growth will be fine (but with some downside risks): This must be the case because 1: Economic growth is usually solid in any given year and 2: It is not a great idea to tell clients that there is a recession looming.   

– Prevailing performance trends are likely to continue but could change: The safest bet is always to say that what has been working recently will continue to perform well next year This makes readers feel comfortable and plays on the propensity of markets to trend / people to extrapolate. It is important, however, to mention something about the potential for a ‘broadening out’ or ‘reversal’ – just in case.

– Alternative asset classes look attractive: Coincidentally, they also happen to have high fees and are difficult to replicate passively.

– A current key structural theme will profoundly impact markets: AI is incredibly important, but look beyond the obvious winners.

– We are at a critical turning point. Something significant is changing in the world order / investment landscape – you need our help to navigate it safely. Whatever you do, don’t be complacent. (Probably AI, again). 

– We should be worried about a loosely-specified tail risk that the market is obsessing over: There is always some tail risk that is concerning investors – it needs to be mentioned even if nobody is quite sure if it is a genuine risk or what to do about it (fiscal sustainability for the second year running).

– Equities will perform well: This is both likely to be true in any given year and avoids panicking readers. (Adjust as appropriate for fixed income / private market outlooks).

—

These annual documents are generally a good, tangible reminder that we are hopeless at forecasting and that financial markets are always a rotating cast of salient topics that feel urgent in the moment but have little predictable bearing on long-term outcomes.

To the extent that short-term issues matter at all, it will be the ones that nobody is expecting that will have a significant market impact.

If read for what they are – a gentle sales pitch with some interesting financial market observations – they are harmless enough, particularly if they, somewhat inadvertently, encourage readers to stay invested over the long-term. But we certainly don’t need to be acting on them and rest assured nobody will remember anything that is being foretold now in 12 months’ time.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

If There Was a Bubble, What Would You Do About It?

/ Joe Wiggins

There has been a lot of talk recently about whether there is a bubble in certain parts of the market, but this might be the wrong question. Perhaps we should instead be asking what we would do about it if there was one. Imagine if you – and only you – knew for certain that there was a bubble in US equities. What action would you take?

Let’s define some terms. You are managing a traditional multi-asset portfolio holding a globally diversified mix of assets for long-term growth. Through an unexpected dose of divinity, you know without any doubt that US equities are in the midst of an investment bubble – that is, valuations are unsustainably high relative to underlying fundamentals and will aggressively revert at some point.*

There is a catch, however. Your ability to see the future does not extend to timing. So, while you know a bubble exists, you have no idea when it will pop.

You know something will happen, but you don’t know when.

How would you adjust your asset allocation?**

For your personal portfolio the answer is probably straightforward: you remove most, if not all, of your US equity exposure and are comfortable being patient (perhaps you simply invest in non-US equity markets).

If, however, you manage money professionally for others, the answer is likely to be very different.

When a professional investor assesses an investment opportunity and decides how to size it, they think primarily about four things (or at least they should):

  • The potential payoffs – the future returns in different scenarios.
  • The probability of each payoff – how likely each return outcome is.
  • The cost of being wrong – the impact if the assumed payoffs and probabilities prove incorrect.
  • The need to survive – how much underperformance we can bear.

The final element – survival – is about understanding that being right isn’t always enough. It is about our ability to withstand the path to validation. It asks:

How can I size a position so that I don’t lose most of my assets, or my job, if it temporarily goes against me?

Drawdowns, whether in absolute terms or relative to a benchmark, are incredibly challenging. And it is not just their depth that matters, but their duration.

If you don’t scale your position for survival through time, then whether you are correct can become an irrelevance. That is why, for professional investors, even the enormous advantage of knowing without any doubt that US equities are in a dangerous bubble would not make allocation decisions easy — unless you also knew the timing.

Imagine you take the bold choice to reduce your exposure to US equities by three-quarters because of your bubble prescience. What if the US market outperforms for the next four years? You will appear completely wrong and probably lose a lot of clients, even though you possess an exceptionally valuable piece of foresight.

When managing a portfolio, sizing is all about survival or gauging your ‘portfolio pain threshold’ – for how long and by how much could you bear a decision appearing wrong, even if it is ultimately right?

This reality of professional investing can lead to behaviours that seem irrational — such as holding an asset you know is in a bubble — but are in fact ultra-rational within the context of surviving the unpredictable nature of markets.

This dynamic makes it essential that professional investors ensure their clients have clear expectations about the approach being adopting and the performance realities that come with it.

Unfortunately, no investor has advance warning of what will happen in the future. We must contend not only with the pain of short-term underperformance when we are right, but also with the uncomfortable truth that we could be completely wrong.

It doesn’t matter how confident we are in our investment thesis: if we don’t consider survival and understand our tolerance for portfolio pain, we might not be around to benefit even if we are ultimately vindicated.

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*This is not a view, just an example for the sake of the post.

** No options or instruments with convex pay-offs are allowed, as that spoils the game. The question is – how would you adjust your allocations in a simple fashion?

This is an excellent piece from alpha architect on why seeing the future wouldn’t stop an active manager getting fired.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

How Can Investors ‘Follow the Evidence’?

/ Joe Wiggins

Following the evidence has become an increasingly important idea in investing in recent years. If we want to make informed decisions, it makes sense to understand what the evidence tells us. Unfortunately, following the evidence will not lead us to a definitive, correct answer – financial markets are far too messy and capricious for that. What evidence we choose to use and how we apply it is highly subjective and involves a host of trade-offs, which can lead reasonable people to disagree.  

Of course, not all evidence is created equal, some is robust and compelling – fees matter a lot to long-term returns and trying to time markets is a bad idea – but much of it is imperfect. A robust piece of evidence may directly contradict another equally strong argument. Investment decision making is about understanding what we are trying to achieve, assessing the available evidence and drawing a necessarily uncertain conclusion. 

To give a sense of how difficult it is to just ‘follow the evidence’, I wanted to give some examples of how the inescapable complexity of financial markets means that investors are perennially forced to make a whole host of subjective calls:

Static asset allocation versus valuation sensitivity: There is plenty of evidence that holding a static 60/40 portfolio allocation is an approach that is hard to beat over time. This idea, however, is probably outweighed by the evidence that valuations are a crucial driver of long-term return and risk. If we are following the evidence, what should we do? If we decide on fixed allocations, we ignore the evidence on valuations, if we make allocation adjustments over time based on changing valuations we ignore the evidence on the cost of taking active views. It is possible to argue either side and cite strong evidence – and this means we need to take a view.

Market cap equity versus equal weight equity: In 2013, a group of academics published a paper looking at alternatives to market cap weighting in equity indices and they found that doing ‘anything’ was better than a cap weighted approach – including portfolios ‘selected by monkeys’. At the time of publication, someone following the evidence could have quite justifiably preferred an equal weighted equity index fund compared to a traditional market cap weighted index fund. If they had done so, their relative performance would have been absolutely trounced in the years that followed. A lovely reward for taking heed of the evidence available. 

Not only would following the evidence have cost them, but the consensus now would be that market cap is superior to other approaches. So, with the benefit of hindsight, it would look like we were not guided by the evidence at all.

Global allocation and private markets: Many long-term investors reasonably take the view that the most prudent approach is to own something akin to the ‘global market portfolio’ and tailor it to their risk appetite. Given that private markets are a decent slice of the investable universe and more feasible access routes are emerging, does that mean these investors should now incorporate such strategies? Maybe. Or perhaps they should consider the evidence that expensive and complex products tend to come at a cost to clients over the long-run. There is an explicit choice to be made.

The small cap effect: On reading Fama and French’s seminal 1992 paper, an evidence-minded investor may have titled their equity portfolio towards smaller firms. The problem is that the evidence since publication has suggested that the size effect is only present in micro-caps, that it only works if you control for quality, or may not exist at all. Not only might seemingly compelling evidence be unreliable, it can also change based on better methods or new information. If you still believe in a small cap premium you are underweighting more recent evidence – which is fine – but it is an active choice that needs to be justified. 

Domestic bias: What does the evidence say about holding a domestic bias in our portfolios? It is a bad idea for most people, unless you happen to live in the US – then it looks like a great one. If I am in the US, should I rely more on the general rule about the cost and risk of a domestic bias, or the specific case of being a US investor? I have an opinion on this, but there will be plenty of people who disagree because of the evidence they choose to use. 

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There are many more examples of this I could give but the broad point is that very few things are simple or easy in the world of investing. The evidence about the investment decisions we should make is opaque, changeable and often conflicting. Even if we have all the relevant information to hand, it still requires us to have opinions and own them. We will never alight upon the right answer, just the one we think makes the most sense to us based on what we observe and who we are.

I am worried that by writing this I am giving a charter to make poor decisions and justify them by saying that because the evidence is incomplete anything goes. This is not the case. It is critical to filter out the nonsense and noise as best we can (and there is a lot of it). Even when we do, however, and are left with only high-quality information, we still have to discard or underweight some parts and emphasise others.

Judging the quality of the evidence available is not just a challenge due to the sheer scale of material available, but the fact that it changes (or at least can appear to).  Does twenty years of data that conflicts with the prior eighty years overwhelm it? When have markets sufficiently changed so that certain information is no longer valid? How valid is that 120-year data set today? Are we in a different regime now? Not only is it difficult to know what evidence should really matter, it is difficult to stick with something that is well-supported by the evidence available because – inevitably – there will be spells when it looks utterly incorrect.

Taking the time to assess the evidence and incorporate it into our decision making is crucial and the key underpinning of any investment process. It doesn’t, however, guarantee that it will lead to positive results – even if we do it well. We should, of course, still try, but we will need a little dose of good luck as well. All we can try to do is get the odds on our side.

I have focused here on the complexity and noisiness of financial market evidence. I have not started to touch upon the way in which we as individuals source, interpret and employ evidence – incentives, experience, temperament, environment and many other factors will all have a huge influence on how we engage with it. We are as muddled as the information we use.

Using evidence well is integral to good investment decision making but, unfortunately, there is not only one way to do it nor only one sensible answer to find. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.