Financial markets are enjoying an exceptionally strong finish to 2023. At the time of writing, equities in the US were up over 10% and aggregate bonds 5%. Balanced investors have experienced a very healthy annual return in under three months. Although it is pleasing to close the year with portfolios increasing in value; it is perhaps more useful to think about what such periods tell us about the oddities of financial markets and our own behaviour:

– Predicting the short-term fluctuations of markets is incredibly difficult to do well and enormously damaging when done badly. It’s best to avoid it. 

– Although it might make us feel good right now, the high returns of this quarter means that long-term, regular savers will be investing at more expensive valuations and lower yields.

– Financial assets behave a little like a Veblen good – demand for them tends to increase as the ‘price’ increases. Or, to put it another way, as expected returns fall, demand rises.

– The movement in asset prices over the fourth quarter of 2023 has little to do with the valuation of long-term cash flows but a lot to do with momentum.

– Most investors (certainly those making shorter horizon decisions) are simply engaged in a circle game of predicting how other people like them will react to certain market / economic developments. (If the Fed do X, other investors will do Y, so I will do Y, and so it continues).

– Price performance creates market narratives, not the other way around. Most stories are a persuasive post-hoc rationalisation of events. Financial market movements are typically a mystery before the fact and obvious after.  

– When we enjoy periods of strong performance, we should apply a mirror and ask how we would feel if we were experiencing losses of similar magnitude.  

– Periods of extreme are dangerous for investors in both directions – they create unduly ebullient or pessimistic expectations and lure us into irrational extrapolations. Bad decisions get made at extremes.

– What has happened recently carries far more weight in our thinking than it really should.

– The fear of missing out (markets up) or the fear of being involved (markets down) are most acute during periods of abnormally positive or weak performance.

– Short run equity returns are volatile and unpredictable. If they weren’t, their long-run returns would be much lower.

—

Investors should try to treat periods of unusual performance with equanimity. Over the long-run they are unlikely to matter that much; unless, of course, they lure us into poor decisions.

–

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).

Paul Richards and I downed some eggnog and decided to record an impromptu ‘Decision Nerds’ Christmas special. In the pod, we chat about how insights from behavioural science might help the holidays proceed more smoothly. This includes:

– Why I am worried that my Christmas gifts might make me look like an ‘egotistical a*&hole’.

– Why Paul sets very low expectations for Christmas.

– The nudges that retailers use to get us to buy.

– Gift cards or cash as a present – to constrain or not to constrain?

– Do New Year’s resolutions get a bad rap and how can we structure them to give a better chance of success?

Our favourite Christmas movie as a metaphor for decision-making and a gift that helps people understand their value to the world. (It’s not Die Hard).

Wherever you are, however you celebrate (or don’t), we hope that you have some high-quality time with family and friends over the festive period.

Available from all your favourite pod places, or below.

Christmas Behaviour

It is that time again when many investment professionals make predictions about how equity markets will perform over the coming 12 months. The only purpose of which seems to be allowing us to look back in a year’s time and comment on how pointless such endeavours are. Although it can be viewed as a harmless diversion, the pervasive culture of forecasting the unforecastable perpetuates damaging investor behaviour.

When setting expectations for equity markets for the year ahead, it is important to understand what it is actually being done. In simple terms, equity returns have three drivers – changes in valuation, dividend payments and earnings growth. Over short horizons it is often valuation changes (or what we might also call fluctuating sentiment) that dominate; whilst as the horizon extends it is cash flows and their growth that matters.

When we forecast the year ahead in equity markets, it is largely an exercise in anticipating changes in sentiment. In essence we are asking – how will the market (other investors) react to future events? Which is quite tricky.

If we are attempting to forecast equity market performance in 2024, we need to do three things:

1) Identify known issues or developments that will influence investor sentiment in 2024 and accurately predict them. (For example, we would need to know both that the action of The Fed will be influential and how they will behave).

2) Identify unknown issues that will influence investor sentiment in 2024 and correctly forecast them. (This is, by definition, impossible).

3) Foresee how markets will react to these known unknowns and unknown unknowns. (We don’t need to just get the events right, but the market’s reaction to them).

Although this may seem glib, it is not. It is exactly what is required to make such a forecast. It is a prediction of the market’s reaction to unpredictable events and events we haven’t even thought about.  

Given the improbability of meeting this challenge, why do so many people do it?

– It’s expected: Unfortunately, the most persuasive reason is that such short-termism is an unshakeable industry standard. I have worked in investment markets for twenty years and when people ask me about what I expect ‘the market’ to do next year I feel embarrassed saying “I have no idea”, even though it should be more embarrassing actually offering a confident forecast.

– It’s their job: For many people it is simply their job to produce such forecasts, whether they believe it has value or not.

– They believe it: Presumably some people believe there is merit in such forecasts, which I can only put down to overconfidence.

– It’s fun: Predicting short-term equity market performance is enjoyable and engaging. People want to keep doing things that are interesting and might keep doing them even if it destroys value over the long-run.

But what if we had to forecast equity market performance in 2024? What would be the ‘right’ way to do it? Probably by looking at some base rates of historic one year returns and perhaps adjusting those to reflect starting valuations. The final step would be to put some extraordinarily wide confidence intervals around the prediction, immediately rendering it pointless.

The truth is most people owning equities should be doing so to capture long-run returns by investing in a collection of companies generating a rising stream of real cash flows through time. Attempts to predict how the market might be pricing those cash flows over any given year is entirely fruitless and counterproductive. *

This is not simply a case of more wildly inaccurate forecasts in financial markets, but another example of the incessant implicit encouragement of damaging investor behaviour. The more we see these types of predictions, the more people think that equity markets are somehow stable rather than noisy, and that investing is about making short-run estimates of impossibly complex things.

We need to spend less time on spurious forecasts and more time on educating investors about what really matters.

How will equity markets perform in 2024? I have no idea.

—

* Even if we knew the ‘fair value’ of equity markets, there is no reason to believe that markets are ever attempting to ‘find’ this price. Why Should Equities Be Fairly Valued?

—

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).

Being an investor is like walking into a casino and seeing everyone crowded around a table playing the game with the worst odds of success. We seem inexplicably drawn towards activities – such as timing the short-term fluctuations of markets or taking aggressive, concentrated bets – where the chances of positive outcomes are poor, yet we carry on regardless. Why can’t we resist playing what seem like the wrong games?

– We don’t know the odds of the game: We can either be oblivious to or wilfully ignorant of the probabilities attached to the activity we are undertaking. Although this is undoubtedly common, it shouldn’t be. Understanding the base rates of success should be the first thing we do.

– We have unusual skill in the game: Assuming we are playing for more than just entertainment, the only reason to engage in a game where the odds for the average player are poor is if we are uncommonly skilful.

– We are overconfident in our own abilities: The problem with believing that we are remarkably talented is that we probably aren’t. We are far more likely to have an unjustified, inflated view of our own capabilities and erroneously believe that the odds do not apply to us.

– The game is exciting and fun to play: We play games where there is a high chance of failure if they are enjoyable, entertaining and engaging. The challenge for investors is that it is the boring stuff that works. And nobody wants to play a dull game.

– Lots of people are playing the game: If everyone else is involved in the game then we might as well join in. Not only is social proof important here (there is validation and comfort in doing the same as other people); but there becomes an expectation that we should be doing the same – we are an oddity if we don’t do it.

– We get paid to play the game: If we are paid just for playing then the odds of success matter less.

– The outcomes are asymmetric: Low probability games are attractive to play where we are able to capture a significant portion of the upside payoff, whilst other people bear the downside. (See hedge fund performance fees without clawbacks).

– There are more tables for this game: If a casino has 25 tables of low probability games that are fun to play, noisy and enticing, and a single table with a boring, quiet game with better odds of success – which one will we play? Almost certainly the former.

– We see other people winning at this game: We judge probabilities based not on the actual statistics – but what is available and salient. Huge coverage is granted to those fortunate enough to win big at low probability games and it makes us think that we can do it too. They make films and write books about the outliers and survivors in investing, not the average. 

As investors we spend far too much time focusing on how to win the game we are playing, rather than understanding the reasons we are playing at all.

—

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).