You are standing at the top of an imposing hill. The descent is steep but a little craggy and undulating. In your hands is a basketball. You drop the ball and it begins its journey downward. Are you more confident in predicting that the ball will reach the foot of the hill, or the exact path it will take to get there?

I would hope that most of us are more confident in expecting gravity to take the ball to the bottom of the hill than anticipating the precise, chaotic course it may chart on its way. Yet many investors with long-term horizons are faced with a similar question and seem to prefer obsessing over the journey while losing sight of the end result.

We know the fundamental return drivers of traditional asset classes (particularly equities and bonds), and we can have a solid level of confidence that these will come to pass if our horizons are sufficiently long. Investors, however, often seem to ignore this and instead undertake the hopeless activity of guessing each erratic twist and turn along the way.

Most of us are spending time and money trying to predict exactly how the ball will roll down the hill.

Predicting Chaos

I recently saw a performance of one of my favourite plays – Tom Stoppard’s Arcadia. It covers a vast array of topics, but one of its central themes is the concept of chaotic systems. Valentine, a key character in the ‘modern’ element of the play, has this to say about chaos and the problem it creates for making sensible predictions:

“We are better at predicting events at the edge of the galaxy or inside the nucleus of an atom than whether it will rain on Auntie’s garden party three Sundays from now. Because it turns out the problem is different. We can’t even predict the next drip from a dripping tap when it gets irregular. Each drip sets the conditions for the next; the smallest variation blows the prediction apart.”

Valentine’s words say much about the futility of trying to predict financial market conditions. It is a deeply complex system (it has many, many moving parts), and it is chaotic (the behaviour of one component is highly sensitive to the change in another). Even with relatively simple systems — such as a ball rolling down a hill — it is incredibly difficult to predict variations and fluctuations. The sheer complexity of financial markets is staggering; it is a wonder that anyone attempts to forecast them at all.

We can have a reasonable level of conviction that equities will generate positive real returns over time because there are some fairly stable assumptions at play: economies will grow, companies will generate earnings, and those earnings will compound through time. Of course, the drivers of asset class returns are not as unimpeachable as gravity, even over the long term. But we can have far more confidence in them holding than we can in knowing what markets will do over the next year.

Irresistible Predictions

The ongoing conflict in the Middle East has created something of a prediction frenzy, as investors react to a salient reminder of how unpredictable the world is by trying to forecast a whole host of imponderable things.

Even if we create a very simple model of the world and try to predict how things will play out, we quickly see the superhuman level of foresight that is required.

To make a good investment prediction we would need to know the magnitude and duration of the war, its impact on oil prices, how it affects the global economy, the response of governments and central banks, and how financial markets might react to all of that.

This is an embarrassingly simple construct. It excludes a vast array of important elements and ignores new events that will inevitably occur in the future — events we are not yet even thinking about. Yet even with such a simplified model, we still wouldn’t have a clue how everything might unfold.

In a complex system, all the interactions between factors matter, and they all act on each other in unknowable ways. If you think you can do this well, you need to explain why and how.

Most investors are best placed taking a long-term view that the underlying fundamentals of traditional asset classes will come to pass over time. Rather than attempting the impossible — trying to forecast the fluctuations of those assets while we hold them — we should instead diversify our portfolio in a manner that allows us to withstand a wide range of potential short-term outcomes. This gives us the best chance of making the long-run work for us.

We don’t need to predict how a ball might roll down a hill to be confident that it will reach the bottom.

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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.

From an investor’s perspective, one of the primary challenges in dealing with events such as those unfolding in the Middle East is that, in times of stress and uncertainty, we quickly default to our most human instincts. These instincts are almost always at odds with sound investment decision-making. We stop doing the things we know work and get lured back into doing the things we know don’t.

The things we don’t know:

• How the situation in the Middle East will develop.
  
• What the short and long-term geopolitical and economic implications will be.
  
• How actions in the Middle East will interact with a multitude of other relevant dynamics in the months ahead.
  
• How financial markets will respond to any of these developments.
  
• Which issue might be the focus of investor attention next month.

The things we do know:

• Even those with considerable expertise cannot hope to forecast the unfolding consequences of geopolitical events.
  
• Predicting the first, second, and third-order financial market impact is even harder.
  
• Short-term volatility in markets is unlikely to have a predictable impact on long-run outcomes.
  
• High real returns for holding equities over the long term are compensation for bearing short‑term volatility.
  
• At some point in the future, equity markets will decline sharply because of some unforeseeable negative occurrence.
  
• Humans often hugely overweight high-profile and salient risks.
  
• Humans make poor decisions when emotions are heightened.
  
• Diversification is the best protection against an uncertainty.

Managing our behaviour as investors is about subduing some of our most human urges – urges that are useful in many contexts but typically disastrous for long‑term investment decision-making. Yet in conditions of uncertainty and anxiety, the compulsion to take action, to predict the unpredictable, and to focus solely on the immediate future often becomes overwhelming.

When we most need to remember what we know, we tend to forget it.

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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.