Which modern US presidential election has had the most significant impact on long-run asset class returns? I have no clue, but I am going to confidently tell you how financial markets will react to the upcoming one. Major events matter a great deal to investors even though history tells us that it is impossibly difficult to foresee their consequences, or indeed know whether they will matter at all over the long-term.

Ignorance would be bliss

The most obvious reason that noteworthy events, like presidential elections, are so diverting is that they are inescapable. We cannot help but have our attention drawn to them, and we consistently overweight the significance of things that are salient and available – that which is happening right in front of our eyes. To make matters more difficult, events like elections can have great importance in certain aspects of our lives, but not have much bearing on the long-term success of our investments. It is incredibly difficult to disentangle this – when an issue is relevant, we cannot help but think it is relevant everywhere and to everything.

It is also almost impossible for an investor to remain indifferent to a topic over which the asset management industry is obsessing. The fact that everyone has a forthright opinion on a subject bestows a significance upon it. We can join the party, or risk appearing negligent.

The threat of being labelled as inattentive to a profoundly consequential occurrence is exacerbated by the fact that – over the short-term – events like presidential elections will have an impact on financial markets. Many investors are involved in playing a game of predicting how other investors will react to a certain development: If x wins the election, then y sector will benefit – this type of behaviour is self-perpetuating. Markets move on events because investors expect markets to move on events. Although engaging in such speculative activity is unlikely to be beneficial, it does make doing nothing challenging – “you said elections were irrelevant, but look how markets have reacted”.

During such times it is easy to do things that are positive for how we are perceived, but negative for what we are trying to achieve.

Even if we are resolute enough to ignore the noisy, near-term ramifications of high-profile market events, surely they sometimes have longer-term consequences? It is possible, but requires us to predict profound structural changes in financial markets or economic conditions. It is far from easy to link an isolated past event to subsequent market performance – believing that we can do it for the future seems fanciful.

Complex problems

When we consider major events it is inevitably in a deterministic fashion. We believe that an event will precipitate a specific reaction, but that is not how complex systems work. They are chaotic and unpredictable. The result of one binary event (such as an election) could set us off on a million different paths, based on the disordered interactions of an incalculable number of variables. A deterministic approach makes us feel comfortable amidst substantial uncertainty, but it is in no way a reflection of reality. Investors might want it to be one way, but it is the other.

The best evidence of the challenge of making predictions around the financial market implications of events is how little time is spent reflecting on our previous forecasts. When a pundit spells out the consequences of the coming election result, how often do they inform us of their prior prescience around historic elections? On average, never. This is not just because they were probably wrong and that might inhibit our confidence in them, but because when we look back we will see quite how messy everything that followed was and how difficult it is to draw clear lines of causality. The US election is unlikely to be an epochal event that fundamentally changes the long-term financial market outlook (certainly not in a predictable way).

A common approach to simplifying the logic around how financial markets might behave around an election is to look at past instances of the same event. The problem of this – particularly when they are relatively rare – is that the sample size is inescapably miniscule, and each instance is influenced by a specific set of variables that were relevant only at that time. Confidently drawing inferences from such analysis is fraught with danger.     

Managing event risk

If engaging in speculation and prediction around the US election is unlikely to be prudent, what should investors do – just ignore it? Yes and no. Most investors with sensibly diversified portfolios haven’t really ignored this event or any others, they have instead used the principles of diversification when building their portfolios to reflect the fact that the future is inherently uncertain (and that includes event risk). A well-diversified portfolio is one which is robust to a range of different outcomes in financial markets – sufficiently resilient in the short-term to meet long-term goals. Unless we have a high conviction that the election materially changes the risk and return characteristics of key asset classes, our best approach is to do nothing and stay diversified.

When event risk is on the horizon, investors often gain comfort from running stress tests and scenario analysis on their portfolios, this can be problematic. As the saying (sort of) goes: all models are wrong, some are also useless. While it can – if framed with the appropriate context and caveats – be very helpful to understand the potential range of outcomes faced by a portfolio; tests that attempt to specify how asset classes will behave following a particular event are inevitably founded upon unrealistic and overconfident assumptions about the future. They can give us a false sense of certainty and should be handled with the utmost scepticism.

A stress test that would be beneficial for investors would be one that warns us of the type of poor decisions we are liable to make when under stress. These are the stresses that will have a predictable impact on portfolio outcomes.

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Significant events such as the US election present an acute challenge for investors. Sticking to our plans and admitting the limits to our knowledge amidst the maelstrom of pontification and prediction can seem almost impossible. Long-term, well-diversified investors should not despair, however, with a little fortitude it will pass away soon enough.

Until the next event.   

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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).

I recently came across a statement made by Warren Buffett in a 1965 letter to his Partnership where he mentioned group decision making: “My perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions.” This made me reflect on the fact that the overwhelming majority of the literature and research around behaviour and decision making produced in recent decades has been about how individuals make choices, but in virtually every walk of life – politics, business, family and investing – decisions are frequently made by groups of people. Despite this little time appears to be spent seeking to understand how groups function. This is a severe oversight. If we thought individual choice was confusing and problematic, just wait until we start putting people together.

It is important to define what a group decision actually is. For me there are two key features:

1) People ostensibly working together to reach a decision.

2) More than one person has the ability to materially influence (implicitly or explicitly) the decision made.

A group decision does not have to be a situation where there are 11 people sitting on a committee and each holds a vote, in fact many collective decisions look like individual choices in that a single person makes the ultimate call, but are actually the outcome of group interaction and influence.

Why are most decisions made – in some form – by a group of people? There are two reasons. First is a desire to combine experience and expertise. In theory, better decisions should be made if there is an ability to access higher quality information and inputs. Second because there is a need to represent multiple stakeholders. Where a decision impacts different groups, there is often a requirement to provide an appropriate voice to those parties.  The makeup of most boards and committees should at least attempt to meet these two criteria.

While these both seem laudable aims, they can create profound decision-making problems if not handled considerately (and might still do even if they are). The investment management industry is overrun with implicit and explicit group decision making, but I have barely ever heard anyone talk coherently about how groups have been brought together. Yes, in recent years lip service has frequently been paid to the notion of cognitive diversity, but I have severe doubts that many people using the term have a clear idea of what it means and its implications.

Imagine involving a group of people in a decision all of whom have different personalities, incentives and beliefs, and expecting that to result in a coherent outcome. It seems entirely non-sensical, but this is exactly what occurs in most group decision making scenarios.

It is not that the construction of decision-making groups is random – there is generally some credible reason as to why people become involved in a decision – it is just that there is an inescapable complacency about how or why the interactions of the group will impact the type of choices being made. This almost inevitably leads to unintended consequences and undesirable outcomes.

There are several critical issues to consider when trying to avoid the major challenges of group decisions:

Goals and incentives:  The essential condition for effective group decision making is shared goals and aligned incentives. If the individuals with influence over a choice are not attempting to achieve the same objective then any decision it makes is likely to be greatly compromised. Organisations where group decisions take place are typically incredibly complacent about this, assuming that ‘of course’ all people involved have the same objectives. This is rarely the case, usually because the personal incentives of individuals are wildly misaligned.

The critical question to ask is – what is the primary incentive / aim of an individual involved in this decision? To take a heavily stylised example: Imagine there is a portfolio manager and a risk manager in a group involved in making an investment recommendation. The portfolio manager’s primary aim it to maximise return, the risk manager’s is to avoid disaster. These are both rational positions to take for them as individuals but it is very unlikely to lead to rational decisions at a group level – they have skin in different games. Now imagine it is not two people involved in an investment decision, but 17 all with somewhat contrasting motivations.

This is not to say that individuals with different specialisms and areas of focus cannot be involved in an effective group decision, it is just that for it to work they have to have their incentives aligned. Most groups involve a collection of people optimising for different things, resulting in sub-optimal results.

Philosophy and values: Consistent goals are integral to effective group decision making, but almost as important is shared philosophy and values. This does not mean that individuals within a collective have to think in the same way or attempt to tackle each problem in an identical fashion, but they must hold a set of common beliefs about the best way to reach their objectives. Group members can challenge each other without challenging their identity.

Decision making groups with a shared philosophy can discuss and debate the nuances of how best to apply that set of beliefs to the problem that they are trying to solve. Groups with philosophical differences will forever be trapped in unresolvable debates, often making little progress.

Accountability sinks: One of the primary risks of group decision making is the creation of what economist Dan Davies calls “accountability sinks”. This is where organisations remove individual accountability for decisions and instead place it into amorphous groups, policies and procedures. This creates a situation where nobody is to blame for anything – the system has responsibility. This can be quite attractive for people because being held to account is often unappealing, but it can lead to bad decisions, the complete removal of agency and chronic inflexibility.  The atrocious Horizon IT scandal that recently engulfed the British Post Office, is almost inevitably an extreme example of horrendous group / system-led decision making.  

Decisions can be categorised on a spectrum from those that feature individual accountability to those where there is no obvious accountability:

– Individual (Single accountability)
– Group (Shared accountability)
– Multiple Groups (Vague accountability)
– System (No accountability)

This is not to say that individual, sole responsibility decision making is always optimal, but we must be aware of the consequences of the shifting accountability structure that occurs as the number of people involved in a decision increases. Individual behaviour alters dramatically if we have 100% responsibility, compared to no ultimate responsibility.

Implicit group decisions: Another major accountability problem arises when decisions appear to have individual accountability but are actually heavily impacted or constrained by others. Similar to accountability sinks, this can be appealing for most group members because they can exert material influence without any consequence for their actions. It is not, however, appealing for the individual who is deemed to be the decision maker.  Davies, again, has a simple test for whether someone deserves to be accountable:  

“The fundamental law of accountability, the extent to which you are able to change a decision is precisely the extent to which you can be held accountability for it, and vice-versa”

It is quite common for individuals (or other groups) to hold the ability to materially alter a decision while seemingly being a great distance from any accountability for it. This typically occurs when people are able to apply constraints to a decision; here the accountable decision maker appears to have full responsibility for the ultimate course of action taken, but their set of options has already been greatly reduced by others.

This type of scenario often precedes the formation of accountability sinks – as when the accountable individual realises that they hold little agency they baulk at this arrangement, and prefer something more anonymous.

When assessing a group decision structure, it is vital to look at everyone with involvement and ask which individuals (or groups) have the power to significantly shape the ultimate choices being made.   

Accountability shields: A less common structure for a group decision is an accountability shield. In this situation, one dominant and influential party has an overwhelming power to dictate decision making. They are, however, reticent to bear responsibility for potentially negative outcomes and therefore create what appears like a group / committee / board structure to insulate them from full accountability. This creates an attractive asymmetry for the individual who holds power. The groups involved are functionally pointless, bar providing some protection in the event of disappointing results.

Groupthink: Although most of us never seriously consider the implications of group decision making, there is one topic that is always mentioned if the subject is raised – groupthink. This is a situation where a collective makes a poor decision because there is not enough challenge or critique from within the group. While this can be a valid concern, the issue is nuanced. Certain elements which may be classed as groupthink – such as shared ethos, values and principles – are an integral part of a cohesive group structure. It is, however, crucial that a broadly shared philosophy is allied with psychological safety, freedom of expression and a diverse set of skills. For harmonious groups to be effective they must be able to allow new ideas to permeate and accept that they can be wrong.

Groupthink is undoubtedly an issue worthy of serious consideration, but attempting to mitigate it by putting together a collection of ideologically opposed individuals with conflicting incentives is a bad idea.

The behavioural melting pot: Individual decision making is chaotic and idiosyncratic. Group decision making takes all of our personal foibles, puts them into a pot and stirs. It is impossible to understand how the choices made by groups will react to this confluence. As much as we might try to refine and reshape a group to improve its decision-making capabilities, a significant element will remain the wholly unpredictable noise that emerges from a convergence of personal behavioural biases.

Power dynamics: Power is perhaps only second to incentives in understanding what drives human behaviour. If we have a clear understanding of individual incentives and the power dynamic at play in any given situation, we can get a long way to understanding the choices that are likely to be made. Talking and thinking about how power impacts the workings of a group is unfortunately something few people are comfortable discussing, probably because we are reticent to upset the people that wield the power. In large organisations power doesn’t have to be held by individuals, it can be held by the system – a structure of policies, procedures and groups can wield an overwhelming but largely silent power.

Group size: When attention is given to group decision making, a common question pertains to the appropriate size of the group – what is the most effective number of participants? There is no right or simple answer here – it depends on the type of decision being made. One overlooked consideration is seeking to understand exactly how large a decision-making group is, which in many cases we probably don’t really know. Returning to my original criteria – we need to identify the people who both have input and can influence a decision. That is our real group size, which could be very different to the number of people sitting on a formal committee or board.

A large group size does have benefits as it should bring with it a greater diversity of skill and provide a voice to multiple stakeholders (where relevant). This notion only holds, however, if some deliberate thought is given to its construction. The main issue with sizeable groups is that most of the problems discussed in this piece become more likely and more pernicious the larger they get.

Group size and composition have a huge bearing on the type and quality of decisions made, but we pay barely any meaningful attention to them.

What defines a group that makes high quality decisions?

The sheer complexity of group decision making may make it seem like a problem that is not even worth confronting, but given how influential these dynamics are to most of the choices we make it is not something that we can continue to ignore. As always, the best way to deal with something that appears unfathomably complicated is to apply some simplicity to it. To my mind, there are three characteristics that a group needs to possess to have a chance of making smart choices:

1) Aligned goals and incentives:  A high-quality decision-making group must have shared goals – they have to be trying to achieve the same thing.  Companies tend to get this spectacularly wrong by creating vague purpose statements that will have no meaningful impact on anyone’s behaviour. Shared group goals are derived from shared individual incentives. Do good and bad outcomes look the same for each member of the group?

2) Shared philosophy and values: A consistent set of values held by the group members is essential for high quality decisions. This doesn’t mean that they need to agree on every aspect of a task or problem, but rather there are no major philosophical gaps between individuals. If there are then the group is likely to fall at the first hurdle. Shared principles should be the foundation of any effective group.  

3) Complementary skills: The key reason for having a group decide is that it grants input and influence to individuals with distinct and complementary skillsets. The more complex the task, the more useful this can be. The key challenge here is that people fall into what football fans might think of as the ‘Paris Saint-Germain trap’ (or maybe the English national team) where we believe that an effective group is simply a collection of the most ‘talented’ individuals. This approach almost always ends badly as it disregards the vital notion that a strong team combines different characters, skills and expertise to meet a particular goal. Haphazardly combining some good individual decision makers will not create an effective decision-making group.

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I often find myself frustrated at the lack of thought given to individual decision making, but this pales into comparison with the neglect of group decisions. The majority of the choices that we make (particularly in a professional context) are made by some form of collective, but we spend incredibly little time considering how groups function and the type of choices they are liable to make. It is undoubtedly a messy and intricate topic, but most of us don’t even try to get the basics right. Instead groups risk being blighted by murky accountability, misaligned incentives, opacity and compromise – not the ideal setup for sound 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).

What will the Fed do next? How will conflict in the Middle East impact the oil price? What does a new bout of stimulus mean for the Chinese Equity market? Is the US economy heading into a recession or reflation? Investors are trapped in a vortex of noise. We are compelled to engage with and react to a rotating cast of inescapably prominent and impossibly complex issues. This constant state of flux is the lifeblood of the investment industry but poison for clients. For most investors 99%, of what we see, hear and feel in financial markets is not just irrelevant to what we are trying to achieve, it actively makes it harder to make good decisions and attain our goals. Why is noise so ubiquitous and what can we do about it?

Critical to the success of any investor is the ability to cancel out the noise that surrounds us and focus on the elements that will have a material influence on our outcomes. Given the sheer complexity and chaos inherent in financial markets this can seem like an impossible task – how can we figure out what is significant?

There are two key criteria we can apply to help us identify harmful noise in financial markets (which is the vast majority of what we encounter). For any issue or event, we should ask two questions:

– Does it matter?

– Is it knowable?

Unless we can answer both in the affirmative, we can classify it as unhelpful noise.

Let’s take each in turn:

– Does it matter? Here we are seeking to understand whether the subject we are focusing on will actually matter to what we are trying to achieve. Let’s assume I have a 20-year investment horizon, will the next decision by the Fed have any obvious impact on my investment goals? Absolutely not. The same can be said for whatever geopolitical issue is the focus of our attention at any given point in time. If something is likely to have either no effect or a random influence on us meeting our investment objectives, then it is just noise. Spending time thinking about it is likely to leave us worse off. 

Even if something does matter – we are confident that some variable or topic will have a material impact on our investments over the time horizons that matter to us – it can still be noise, because it also must be knowable.

– Is it knowable? Being confident that something actually matters is a pretty high hurdle for investment information, but even that is not sufficient. For it not to be noise, it must be knowable or predictable. Why? Well, let’s say I was certain that the near-term decisions of the Fed or the latest geopolitical issue would have an impact on meeting my investment objectives – this is only meaningful if I know or can predict the outcome of these things. I need to know both that the Fed decision matters and believe that I can predict it, otherwise, what am I going to do about it?

If that isn’t tough enough, there is another problem. We often need to know two things – both what is going to happen and how it will impact financial markets. Many wonderful (lucky) predictions about a particular event have been rendered worthless because someone got the second part wrong. Forecasting any future occurrence is usually a herculean task, adding on a prediction of how it will then influence something else (alongside all the other unforeseeable things that might also impact it) is getting us pretty close to impossible.

So, how can we tell what matters and what is knowable? Well, we can apply some simple tests.

Does it matter?

Test: If I had a crystal ball and knew something would occur in advance, would it change my investment decision making?

This is a useful test for long-term investors because most things really should not influence our choices. There is a danger, however, of being overconfident and believing that certain pieces of information will move markets in an obvious way. Imagine having some foresight of 2020 ‘Covid’ economic data and making investment decisions based on that – it probably would have ended badly.

Is it knowable?

Test: Is the information already known or is there evidence that people can accurately predict it?

The most obvious piece of information that is in some way knowable is the valuation of an asset. For example, when bond yields were close to zero we didn’t need to make predictions about future returns being low – we knew this. Unfortunately, most financial market relevant activity isn’t knowable, it is instead reliant on making bold predictions about the future, which in complex adaptive systems is quite the ask.

Bringing these aspects together creates a simple framework for addressing the issue of noise in financial markets and the many problems it causes investors: 

Does it matter?	Is it knowable?	What to do about it?
Yes	Yes	Use the information
Yes	No	Diversify
No	No	Ignore

When people talk about current hot topics in financial markets – usually in wildly overconfident ways – we should be trying to apply this framework before anything else. Ask does the thing being discussed have any relevance based on my objectives and horizon, and if it does, is it reasonable to believe that it is in anyway knowable or predictable? The vast majority of things we can ignore, some things matter but are unpredictable so we diversify our portfolios, and a select few things really matter and should inform the investment decisions we make.

It is fair to say that what matters depends on the individual investor and what they are trying to achieve. So, for short-term traders many more events and occurrences will seem to matter because they are trying to judge near-term changes in sentiment. It is expected that they will interact with the market more than those with a longer horizon. The problem for investors taking such short-run perspectives is that most of the variables that might matter for them are not predictable in any reasonable or consistent way.

Using this framework leaves something of a puzzle, however. Most investors have long-term objectives, yet almost everyone seems to be obsessed with perpetuating short-term noise – constantly talking about things that don’t matter and / or are unknown and unpredictable. What causes such a dynamic? There are many, many factors at play, but here are a few ideas:

We want to reduce uncertainty: As humans we abhor uncertainty, and there are few things more uncertain than short-term financial market fluctuations. Engaging with what is happening and listening to people who confidently explain it (and predict how it will develop) is incredibly comforting. The sense of security it gives us is entirely false, but it feels real.   

We react to what is in front of us: Even if we try to avoid it, we are surrounded by news of what is unfolding right now and cannot help but think that what is happening in the moment is more important than anything else. 

We want to sound smart:  Talking about financial markets makes us sound smart. We can quite easily be wrong about how every major financial market event unfolds yet still sound credible and intelligent whilst doing it. The alternative is to say “I don’t know” or “it probably doesn’t matter” and that doesn’t do wonders for our conversations or career.

We don’t want to look negligent: One of the real challenges faced when trying not to engage with market noise, is that there will always be some events that will have an impact and matter (particularly in the short-run). We won’t know what these are beforehand, but after they occur everyone will act as if they were obvious and inevitable. We cannot risk looking negligent, so it is safer to treat everything as if it might be vital.

We avoid feedback: Does anybody genuinely keep track of the views they have on market events and short-term market moves? Almost certainly not. Everyone knows why this is, but it doesn’t matter because everyone carries on in the same fashion. ‘I was wrong yesterday and the day before that, but I will be right tomorrow.’

We focus on what matters to others: Unfortunately, it is not the things that matter to our long-term outcomes that are most important, but what other people think matters. If everyone else in the industry treats certain events or issues with the utmost significance, it is almost impossible to be an outlier. The industry acts as if these things are important, so clients think they are important, and it is rational to conform.

We want to sell something: Everything always in the end comes down to incentives. Noise, news flow and the conveyor belt of market events grease the wheels of almost everything that happens in the industry. It is in the interests of everyone to join in (apart from the clients).

We are bored: The willingness of investors to engage with market noise always reminds me of a social psychology experiment where participants were left alone in a room for fifteen minutes. They could either sit and think, or press a button that would give them an electric shock. 67% of men chose to electrocute themselves. Long-term investing is usually dull, embracing the noise of financial markets might be painful, but at least it stops us being bored.

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I often wonder whether the majority of people involved in the investment industry know that much of what is discussed and debated on a day-to-day basis is often irrelevant and almost always unpredictable, and just play along with the game, or if they actually believe that they stand apart from everyone else in their ability to make sense of the cacophony. Whatever the case, noise is a real problem for most investors and one that can lead to poor long-term outcomes unless we find ways to drown it out.

The next time you get drawn into a conversation about the latest market event try stopping yourself and first asking – does this matter and is it knowable? The answer will usually be no. 

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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).