At the start of the last decade everyone was bullish on emerging market equities. It is hard to recall now, but it was the consensus trade. You couldn’t attend a meeting or conference without being told how many people there were in China or how underwhelming the growth prospects were for developed economies compared to their emerging counterparts. The irresistible optimism was to prove unfounded as the asset class delivered a prolonged spell of underwhelming performance. This disappointment is merely one prominent example of perhaps the most common (and often damaging) investor behaviour; we take past performance, combine it with a persuasive story and extrapolate into the future.
Dealing with uncertainty
Our desire to extrapolate is an understandable reaction to the uncertainty of financial markets. If we cannot predict the future then our best approach may be to assume a continuation of previous trends. It is not, however, simply a case of presuming performance patterns will persist; the power of extrapolation comes from the narrative that we use to explain what has happened in the past. The stories we tell are what make us believe that things will continue.
When themes or narratives are discussed regarding investment decisions; it is often done in such a way that suggests that the story is driving the price. This is misleading. On many occasions the reverse is true – our inability to explain complex, chaotic markets means that we wrap a compelling narrative around the performance after it has occurred. Extrapolation in investment is driven by a circular relationship between these two elements. Performance creates story creates performance.
These post-hoc rationalisations are hugely problematic however. Whilst the futility of market forecasts and predictions about future market movements is often discussed, this doesn’t go far enough. On most occasions it is difficult to provide robust and complete explanations for market movements even after the event. If markets are largely chaotic and random then simply observing outcomes does not mean you can then draw a straight line of cause and effect.
We cannot confidently explain the past in financial markets, let alone predict the future. Given this, how do we construct narratives that support our desire to extrapolate? We simplify. Let’s take the argument that reinforced the extrapolation of emerging market outperformance in 2010; fundamentally, it can be distilled to this: economic growth in emerging markets will be higher than in developed markets in the future.
Although a naive and fragile argument; from an extrapolation perspective it is incredibly powerful because it is easy and ‘feels’ right – of course you want to invest in higher growth markets. Also, crucially, there was evidence to support it. By evidence, I mean that in the prior decade emerging market equities hugely outperformed and emerging market economic growth was higher than developed markets. Whether the relationship between these two variables is strong or not (it’s not) is immaterial – what matters is whether the story is a convincing explanation of performance. Once the link is forged between narrative and price, it becomes hard to break. Any attempts to refute it are met with puzzlement – “of course it is right, haven’t you seen the performance?”
Creating a simple, powerful story to describe historic performance is ineffective and illusory, but it is also relatively harmless if all we are doing is explaining the past. Unfortunately, that is not all we are doing. The narratives we create don’t just help us decipher yesterday; they set our expectations for tomorrow. We believe that if our story still holds, then performance will persist.
Extrapolation in three easy steps
Extrapolation is an exercise in simplifying things that are uncertain or unknowable in order to make some form of prediction. The process for extrapolation in investment contains three crucial steps:
1) Take a significant performance pattern: Performance needs to be meaningful and sustained – a convincing narrative is hard to forge if returns are noisy or absent a convincing trend.
2) Construct simple explanatory narrative: Markets are too complex to understand or define the precise drivers of previous performance. With a great deal of effort we can make educated guesses, but it is far easier to simplify the task by creating a straightforward explanation that is understandable, convincing and difficult to refute.
3) Consider whether the narrative holds into the future: Our desire to weave simple, intuitive and optically powerful explanations often means that we assume the performance trend will continue provided the narrative explanation holds. If emerging markets grow faster than developed markets their equity markets will continue to outperform, if rates stay low quality will outperform value etc…
We create a compelling narrative to justify why past performance has been particularly strong or weak. We then use that same narrative to predict its continuation.
The problem with extrapolation
Investors can and do make money from the propensity of other investors to extrapolate, but whilst it creates opportunities; it also causes a host of problems:
– Extrapolation is an exercise in simple forecasting: Our explanation for what happened in the past quickly becomes our prediction for the future. This is dangerous because we cannot accurately explain the past let alone predict the future. Even in the event that we are correct in our diagnosis of the drivers of previous returns; it is unlikely that they will persist unchecked.
– We often imply structural changes when extrapolating: Although much market behaviour is inherently cyclical, when we extrapolate it often tends toward being a structural pronouncement. Things are either in a new paradigm or dead, rather than be in some form of natural cyclical decline or boom. This is because when we extrapolate we do so in perpetual terms – this will continue indefinitely.
– Stories are often wrong and missing key variables: The narratives we utilise are almost always too simplistic to be meaningful or even close to comprehensive. Sometimes they are entirely wrong. Yet when it comes to stories it is not the validity that matters but the coherence. There will be some occasions in financial markets when Occam’s razor does apply – and a simple explanation does fit – but it has to be supported by robust evidence, not just be a convincing yarn.
– Extrapolation can leave us concentrated and overconfident: The longer a performance trend persists and the more investors participate, the more the underpinning narrative is bolstered. Our growing assurance can leave us unable to see any other environment prevailing; indeed, doing anything but following the dominant trend probably comes at a cost. It is at these times when we are most vulnerable to abandoning sensible investment disciplines such as diversification. After all, the more certain you are about the future, the less you need to diversify.
Extrapolation is simple. If something has worked well in the past you don’t have to expend any energy explaining why it will work in the future – the evidence is in front of you. It is easy to convince yourself and it is easy to sell to other people (try marketing an investment strategy that hasn’t worked for the last five years). As investors we use it persistently; whether it is thinking about asset class returns, building a portfolio or selecting active managers.
Extrapolation can be effective. Performance trends in markets can and do persist for prolonged periods. Yet exploiting these trends is more about understanding the behaviour of other investors (the Keynesian beauty contest), than it is ‘knowing’ the fundamental drivers of market performance (past or future) or telling an accurate story.
The central problem with our tendency to extrapolate is that when we do so we are implicitly making unjustifiable assumptions about financial markets: that they are predictable, that there are simple explanations and that things won’t change. Holding such beliefs rarely ends well. Yet despite the pitfalls when performance and narrative align it is hard to imagine that the prevailing trend will ever cease.