When a stock price has been enjoying a strong spell of performance it is increasingly common to see people argue that the move is ‘justified’ because earnings have been growing alongside it. The statement is usually accompanied by a chart a little something like this:

The point typically being made is that the company in question is not expensive because its increasing stock price is simply a reflection of improving fundamentals. This is a very simple and appealing notion, and also one which plays incredibly well visually. The problem is it can be exceptionally misleading as it ignores the critical variables that most long-term equity investors should care about.

Passing over the dual axis skulduggery which is so often apparent when these types of charts are presented, there are two major issues with making claims about the relationship between stock price performance and earnings growth:

1) Mixing the past with the future: EPS numbers are a reflection of the historic earnings of a company, while a stock price should (in theory) be based on expectations about the future earnings potential of a company. The only way that movements in EPS can ‘justify’ a current stock price is if it somehow affords us supreme confidence in the ongoing earnings prospects of that business. It may tell us a little, but it certainly does not give us a good answer to seemingly vital questions such as – how cyclical are the earnings of the business? What structural pressures might come to weigh on future profitability?

2) Ignoring valuations: The other glaring issue with such claims is that they seem to entirely ignore the valuation of the company in question. I appreciate that value has become a somewhat arcane topic but the earnings growth of a business surely has to be considered relative to its valuation. If we are attempting to assess the extent to which the EPS trajectory of a business is fairly reflected in its stock price movements, whether that business is valued on 5x earnings or 50x earnings feels like an important piece of information, but one which is often disregarded.

For a stock price to be fundamentally ‘justified’ in any way, we need to have a view on the valuation of a business relative to its future profitability. Observing a rising stock price and improving EPS really doesn’t help us answer such questions as much as many people seem to assume. Stock price moves can be justified by EPS moves, until they aren’t:

Although this type of comparison might not give us a great deal of information about the worth of a company, it does tell us a lot about the behaviour of investors and corporate management:

It’s all about earnings momentum: I have met many, many active equity investors in my career and I would say the most common approach is one based on earnings momentum; where the aim is to identify companies that are enjoying improving and consistently upgraded EPS. This is often not what is stated in their investment philosophy, but very apparent in their behaviour (there is a stigma attached to momentum investing and, unless you are a quant, nobody likes to admit they do it). The stock price to EPS chart is a simple representation of this type of momentum-driven activity.

This ubiquity of this type of investment approach is self-perpetuating. The more investors react to short-term earnings, the more stock prices react to short-term earnings and further encourage the behaviour. It is also a rational approach for many investors to adopt – if you have a time horizon of one or three years, then taking a momentum-orientated approach is likely the best survival strategy. Although you might care about the valuation of a business, by the time it starts to matter you may well be caring without a job.

Such momentum-led investors are as much, if not more, focused on how other investors will react to fundamental developments in the business, rather than the intrinsic merits of those developments to the business itself. There is nothing inherently wrong with such an approach, it is just different to being concerned about a company’s long-term value.

Corporate myopia: One of the consequences of the preponderance of momentum-orientated investors focused on short-term earnings developments is in executive behaviour. If positive stock price moves are increasingly the result of near-term EPS performance this will inevitably alter the decision making of management (on the assumption that their incentives are aligned with how the stock price performs). It seems reasonable to believe that there will be many occasions when a decision made with the objective of maximising short-term stock price performance is very different to one where the objective is long-term shareholder value maximisation. It would be nice if they were the same, but I seriously doubt they are.

The more short-term investors are, the more short-term management are. And so the cycle continues

The stock price of a company rising alongside its earnings really doesn’t help us understand whether it is justified or not, nor does it give us much indication about the long-term value of a business. Rather such comparisons tell us more about the type of investor we are.

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* Charts comparing long-run equity market performance with earnings growth are fine. We should expect these to be closely related over time.

** To my mind, there are three types of active investors: Momentum, value and noise. Momentum investors care about price and are shorter-term. Value investors care about valuation and are longer term. Noise investors do random stuff and create opportunities for value and momentum investors.

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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).

Perhaps it is the curse of frictionless trading and the rise of social media, or perhaps it is the unusually high returns delivered by global equities over the past decade, but investors seem more sensitive than ever to equity market declines. Even relatively minor ones like those experienced recently provoke dramatic responses.* At times such as these it is important not to lose sight of the fact that the returns from owning equities over the long run are as high as they are because they are volatile and suffer from intermittent drawdowns. We cannot have one without the other.

Starting with a very basic point – if we own a share of a company (hold equity), we carry the potential for a total loss of capital in the event that the business fails, and therefore we require adequate compensation for bearing that risk.

Thankfully, most investors are diversified across a large number of positions and are not entirely exposed to the fortunes of one company. We transfer the specific risk of part-ownership of a single business, to the broader market risk of holding a collection of them. This significantly reduces the range of outcomes we face – although we lose the potential for stratospheric returns from an individual holding, we also greatly diminish the prospect of disaster and complete failure.  

This diversification benefit is an attractive trade-off for most investors, but although it limits one type of acute risk, it does not remove risk entirely. Even diversified equity exposure comes with risks and uncertainty that require compensation. This, however, is a feature not a bug – absent this uncertainty long-term returns would be significantly lower.

I tend to think about the risk to diversified equity investors as stemming from two types of uncertainty – short-term behavioural and long-term fundamental.

The short-term behavioural aspect is consistent with Thaler and Benartzi’s explanation of the ‘equity premium puzzle’. Investors are sharply sensitive to short-term losses and check their portfolios frequently. The daily fluctuations of equity prices create a huge amount of discomfort, which leads to poor behaviours, particularly during times of market or economic stress. The fact that this short-term volatility bears little relevance to the very long-term prospects of the asset class is largely irrelevant as – in the moment we experience it – it feels vital.

This creates a major advantage to investors with a long-term mindset (or the inability to check their portfolio valuations every day) but is far more difficult to capture in practice than in theory.  

The long-term fundamental uncertainty element is simply that we cannot be sure what the results over time from equities will be. Although we can be confident that real returns from diversified exposure to equity markets will be positive if we hold them for twenty years – we don’t know whether this means 5% per year or 9%. Furthermore, we can never entirely discount the potential for very poor results from equities even over the long-run – the likelihood of this may be extremely low, but it is never zero.

These uncertainties combine to create high long run realised and expected returns for equities. If we were absolutely certain that equities would return 10% per year, then they would return a lot less than 10% per year.

There is a reward for bearing that uncertainty, but the catch is we do have to bear it. One of the biggest mistakes investors make is trying to capture the upside of equities while avoiding the downside. Given our dislike for even temporary losses this is entirely understandable, but incredibly dangerous, behaviour – one which is far more likely to act as a drag on performance than enhance it. The probability of us correctly anticipating and navigating each equity market drawdown (or prospect of one) is vanishingly small.

It is typically not the equity market declines that do long-term damage, it is the cost of the poor decisions we make during them. Such mistakes never come with just a one-off cost, they compound over time.

If we want to own equities for the long-term because we believe that they provide higher returns, it is important to understand why this is the case. Not only will this help us to manage the inevitably difficult times, but it will also allow us to shape our behaviour and time horizons to best capture those potentially high returns.  

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* Minor declines, so far. (18^th March 2025)

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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).

Dealing with uncertainty is a constant challenge for investors, and now we are faced with a new and more dangerous variant – Trumpcertainty.

In the latest episode of Decision Nerds, we discuss the behavioural curse of uncertainty and how to cope in environments where it feels extreme.

We cover:

– Why uncertainty can feel worse than a loss.

– The evolutionary history of uncertainty aversion.

– How uncertainty impacts our behaviour.

– Why uncertainty acts as a decision making tax.

– How to communicate about uncertainty.

– What investors should and should not do in environments of heightened uncertainty.

The podcast is available in all of your favourite places, and here:

Dealing with Trumpcertainty

An eternity ago (around four months), financial market commentary was dominated by confident predictions of the investment implications of Trump’s second term and countless descriptions of the inevitable performance advantage of US equities. Since this point, we have seen markets behave in an almost entirely contrary fashion to most of these forecasts (I don’t remember hearing many people call for the outperformance of Chinese and European equities). The problem is no matter how many times we get taught the same lesson about the futility and danger of such behaviour, we just cannot help ourselves.

One of the reasons that we perpetually repeat the same mistakes is that investors are incredibly adept at moving on from the things that we were thinking, saying and doing in the past (even if it is the very recent past) as soon as something else happens. While this does help us avoid coming to terms with the painful realisation of how little we know, it doesn’t help us make better future decisions.

About those ‘Trump trades’

Back in November I wrote that trying to forecast the market impact of the US election was a ‘wretched idea’. This was not due to the sheer unpredictability of Donald Trump, but because the global economy and financial markets are unfathomably complex systems and trying to anticipate them is impossible with any degree of confidence or accuracy.

The very notion that there is a straightforward relationship between a binary event (such as an election) and a financial market reaction (a strengthening dollar) is absurd. There may be self-perpetuating short-term reactions to such occurrences – investors trade based on what they think other investors will do – but, after this, things get incredibly messy, very quickly. Complex systems – like economies – are defined by being comprised of many component parts that interact with eachother, often in entirely unforeseeable and chaotic ways.

The issue is not that some of the higher profile ‘Trump trades’ look wrong at the moment – nobody knows how markets will progress from here – but that this type of investment thinking is totally at odds with reality.

European equities – dead or alive?

It may be hard to believe now, but the general sentiment around European equities in 2024 was almost uniformly negative. The sluggish European economy was blighted by bureaucracy and regulation, and their financial markets would never allow for the growth of hugely profitable technology-orientated firms like the Magnificent 7 in the US. Why would anybody invest in a laggard like Europe?

Well, it only takes two months of outperformance for those narratives to change. Now investors are hastily checking that they have enough exposure to a reawakening European economy. So much for the US being the exceptional market.

The old and new arguments are both ridiculously overconfident. The idea of US exceptionalism became as exaggerated as the dramatic transformation of sentiment towards Europe.  

Investor feelings and behaviour are overwhelming dominated by short-term performance and the stories we create to justify it; most strongly held investing beliefs can withstand about a quarter of underperformance. This is because we are obsessed with what is happening right now and can’t seem to shake the belief that whatever it is will continue. 

The truth is nobody knows whether the recent upturn in fortunes from European equities represents a new trend; we could just as easily revert to the performance patterns that have defined the past decade and more.

The fact that we cannot see the future means that we should always be diversified, and that means holding assets that even we might have written off ourselves.

Defensive investing

One of the more remarkable features of recent market moves is the performance of the European defence stocks. The current fervour for this area is in stark contract to five years prior when investors seemed incredibly keen to add such names to ESG exclusions lists and remove them from portfolios.

I have no wish to opine on the rights and wrongs of removing defence companies from a portfolio, but the dramatic shift in sentiment is a useful reminder not only that the world changes, but how we feel about the world also develops through time. We are all prone to believe that the things we think and feel presently are unshakeable. This is not true, not only will the environment around us evolve, but our perspectives and opinions are likely to alter with it.

What we staunchly believe now, may be very different in five years’ time for a plethora of reasons. We should always ensure our decision making is not so dogmatic that it fails to reflect this possibility.

The other – perhaps unpalatable – point is that our investment preferences are (like everything else) impacted by returns. Exclusions that are driven by genuine values are not always immune performance pressure.

We still can’t predict catalysts

Amongst strong competition, ‘catalyst’ is one of my least favourite investing words. People spend an inordinate amount of time talking and thinking about catalysts, but in the vast majority of cases all they are doing is trying to predict changes in market sentiment. Which, as you may have guessed by now, I do not believe we can do.

Imagine that last year you had a constructive long-term view on European equities because you felt that they were attractively valued – someone would have inevitably said: “That’s great, but what is the catalyst?”

Would you have said:

“Well, I think Trump will be elected as US President and his actions will shake the global world order, this will leave Europeans doubting the reliability of their most powerful ally, which will lead them to loosen fiscal constraints and improve nominal GDP prospects, and this will provide a major boost to earnings and sentiment.”

This would have been incredible foresight and if anyone did predict this, I missed it when reading through the 2025 outlooks.   

Investors see catalysts everywhere when they look at past performance, but most of the time these are just stories told to explain outcomes. Most developments in financial markets do not have individual catalysts but come about due to a confluence of factors. Even on the occasions where there is an obvious singular catalyst – it is typically only observable after the fact.

Performance always comes first, explanations second.

Didn’t know then, and don’t know now

There have been some surprising developments already this year, which might mean that investors are reining in their attempts to forecast the future. Unfortunately not. One of the most puzzling but inevitable investor reactions to being blindsided by market developments is to immediately start trying to predict what comes next.

We were wrong then, but we will be right now.

The quicker we accept all that we cannot know or foresee, the quicker we can make sensible investment decisions that reflect that frustrating but inevitable reality.

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For investors it seems that being consistently wrong is far more comfortable than being uncertain. So, despite the early months of 2025 giving us yet another valuable lesson in what we shouldn’t be doing, we will no doubt carry on regardless.

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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).  

At the 1998 shareholder meeting for Berkshire Hathaway, Warren Buffett said: “We try to think about two things: things that are important and things that are knowable.” Although at first glance this comment can seem quite innocuous, it is an essential idea to understand if we are to successfully navigate the uncertainty and noise of financial markets. Investors are generally quite poor at defining what matters to them and why; and this is a problem which causes all sorts of decision-making challenges. There is, however, a quick way to get better at this – a crystal ball test. 

Before describing the test, let’s reflect on what Buffett is getting at here. He is saying that for his investment approach there are only a select number of elements that will influence results over time and an even smaller number of this group that are knowable (or predictable) to any reasonable extent. That is where his focus is.

Of course, nothing is perfectly knowable, but there are some things that we can have a sufficient level of confidence in, and many others that are, if not random, pretty close to it. The are far more things in the latter group than the former and distinguishing between them is vital.

Before worrying about whether something is knowable, we need to define which factors we believe are important to the success of our investment. How do we do that? Let’s turn to the crystal ball.

We can ask ourselves, and other investors, this question:

“If you had a crystal ball and could see one piece of information in the future that would materially influence this investment view, what would it be?”

We can apply this question to any type of investment – whether it be about an individual stock, or a major asset allocation shift. It should quickly elicit what we think the most important factors are, and then we can judge if there is any chance of us predicting it without the aid of a crystal ball.

Let’s take an example. If I had to take a view on the performance of ten year treasuries over the next five years, what would I want to foresee using the crystal ball? It would be US inflation in five years’ time.

This tells you that – for me – inflation is the most important variable in determining the returns of ten year treasuries over the next five years. Unfortunately, I have no idea what the rate of inflation will be, which obviously will impact how much conviction I would ever take in a view on US treasuries.

We can also invert the crystal ball question to get to a similar answer by asking:

“If you knew the outcome of X in advance, how would it impact your decision?”

If I knew the rate of inflation in the US would be 6% in five years’ time, it would almost certainly influence my view on US treasuries.

This type of question can help us cut short situations where people are debating some financial market issue that is not only unknowable but, even if we could predict it, we wouldn’t know what to do about it. (Elections are the gift that keeps on giving in this regard).

Using Buffett’s important and knowable framing, we can think about the usefulness of a crystal ball in three different ways:

– Something is both important and knowable: A crystal ball might help a little, but not much because we are reasonably confident in the variable anyway. (Think here of things like long-run earnings growth or starting valuations).

–  Something is important and not knowable: A crystal ball is absolutely vital because something matters but we cannot anticipate it.

– Something is not important and not knowable: We can use the crystal ball as a paperweight because even seeing the future is of no use to us.  

Unfortunately, investors are prone to spending far too much time in the latter two groups. Either making decisions that are heavily influenced by variables that are inherently unknowable, or wasting time on things that wouldn’t be useful even if they were knowable (which they aren’t).  

The crystal ball test can be an exceptionally useful means of better understanding what type of investor we and others are. It is particularly effective in gauging what an investors’ true time horizon is (the factors that matter change with our horizon) and what variables are foremost in our thinking.

It is also a great sense check to stop ourselves spending an inordinate amount of time on financial market issues just because they are at the front of everyone’s mind, not because they are consequential.

How best can we incorporate Buffett’s thinking on focusing on what’s important and what is knowable into practice? I think there are seven key aspects. We should:

1) Be clear about the variables that are important to the success of our investment decision. 

2) Understand whether these are sufficiently knowable / predictable.

3) Focus on elements that are both important and knowable.

4) Be aware of things that are important to our view but inherently unknowable.

5) Avoid high conviction investment views that are heavily reliant on unknowable variables.

6) Use diversification to protect against important but unknowable factors.

7) Stop worrying about things that are neither important nor knowable.  

Investors are best served by adopting an approach where the most important determinants of success are also at least somewhat knowable. If we need a crystal ball for good outcomes, I don’t like our chances.

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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).