Only one thing doesn’t change in markets – human behaviour

Investors expect markets to behave logically and reasonably. But they don't. They are wildly capricious. The only way to beat them, says John Stepek, is with a well thought-out, long-term strategy.

190208-markets

Markets have succumbed to another bout of worry.

We were all set to get a deal on Brexit; now everyone's worried that we won't.

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Donald Trump and Xi Jinping were all set to kiss and make up; now everyone's worried that they won't.

This time two years ago, everyone was excited about a period of coordinated global growth; now they're fretting that a recession is just around the corner.

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It's almost as though markets are governed more by our mood swings than any real understanding of what's going on out there.

We expect too much of markets

Markets are capricious creatures. The reason we use them is that they are viewed to be one of the best ways to put prices on scarce resources. And judging by what happens when you try to allocate scarce resources using other means communism, for example markets probably are the best solution we currently have.

But you can put too much faith in them. One thing we're all guilty of as human beings is trying to oversimplify the world in order to boil it down to a set of easily grasped rules of thumb. That's because we only have a limited amount of cognitive bandwidth with which to make sense of our environment (which is not always friendly, and sometimes downright hazardous).

As a result, when we find a good solution for one problem, we try to apply it in all sorts of other areas. It's also not enough for a solution to be "good". We often try to push it until it is "perfect".

And so it is with markets. It's not enough that if you get a hundred strangers to guess independently how many sweeties are in a jar, you'll get a decent stab at the answer. Instead, the price-setting mechanism has to be judged "perfect". Markets at all times incorporate all publicly available information into prices.

So you can't beat the market except by getting lucky, because any known price-changing information is in the price already, and any price-changing info that is coming in the future is, by definition, unknowable. Because you don't have a crystal ball.

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That's the efficient market hypothesis (EMH) in a nutshell. I won't go on about it much more, because unless you are a particularly closeted academic, you probably don't buy into the fundamentalist take on the EMH in any case.

But the EMH does still lie at the heart of a lot of market analysis. It's one of those things that people know is not true, but they act as though it is because it makes it easier to create forecasts and because there's nothing obvious to replace it with.

And partly because of that belief, we expect things to happen in markets for reasons. Take the dip in the market yesterday. There's a good chance that this might just have happened because people suddenly realised that the market has bounced a lot and maybe it's not as cheap or exciting to buy as it was just a month ago.

But that's not a good reason. It's a bit too "just because", for our liking it's not a good story. A better story is to argue that it's because Donald Trump said something a bit dismissive about China. Or that a no-deal Brexit became a little more likely.

Yet the first example is probably the closest to the truth.

217 years of proof that understanding our quirks can be very profitable

The good news is that there are a lot of people who are trying to delve into how markets really work. A very interesting paper Global Factor Premiums has just come out from Dutch investment group Robeco. It looks at how all asset classes (shares, bonds, currencies and commodities) have performed around the world, going back all the way to 1800.

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I'm going to write about the paper a lot more both in Money Morning and in MoneyWeek magazine (there's a lot to it). But the goal of the analysts was to look in more detail at "factors". Put simply, factors are investment styles that enable you to beat the market consistently.

This shouldn't really be possible in an efficient market because once investors realise that you can win consistently by doing one specific thing, they should all start doing that thing, and thus stop it from working. (This is "arbitrage".)

The best-known factors include value (buying cheap stocks pays off in the long run), and trend-following (buy stuff that goes up because it keeps going up). And a key conclusion of the paper is that these factors most definitely do work over time. In other words, if you invest using a certain style, you will do better than average (or at least 217 years' worth of market history suggests this is the case).

The stubborn persistence of these styles over time and across economic conditions, indicates that the basic issue here is human nature, rather than anything to do with the external environment. As Robeco put it in the paper, "our tests reveal very limited evidence of a link between macroeconomic risk and global return factors".

That makes sense. Sir John Templeton is often misquoted as saying that "the four most dangerous words in investment are it's different this time'". In fact, what he said was: "The investors who says, this time is different', when in fact it's virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing."

The reality is that there's always something different this time. There's always something new to contend with: be it new technology like the internet, political upheaval such as Brexit, or even a wild shift in the financial backdrop, such as quantitative easing and tightening.

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The only thing that doesn't change (or if it does, it only changes at the glacial pace of evolution) is human nature. This is why unpleasant cliches such as "buy when there's blood on the streets" exist it tends to work, regardless of the precise reasons for the blood being there in the first place, because human beings over-react in predictable ways.

We'll have a lot more on this in MoneyWeek magazine next week (and it's also a core topic in my forthcoming book, The Sceptical Investor, which is available now for pre-order).

But for today, it's just another reminder don't fret too much about the day-to-day gyrations of the market. Events can sometimes provide opportunities or pose threats, but as long as you have a well thought-out strategy in place that you have built with the long-term in mind, then you should be able to go away and ignore the newspapers for months at a time without doing your wealth any harm. (And you'll probably do your mental health the world of good in doing so.)

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