Markets are a Confidence Trick

The Downside of Paradise

Many investors are experiencing the real downside of stockmarkets for the first time. Suddenly they’re no longer placid, happy holiday resorts where riches gently roll to shore simply by waiting. A volcano has erupted and everyone is running around with their hair on fire stealing each other’s coconuts and hoarding pineapples.

Of course, paradise always had a lurking dark underside and even an unexpected eruption will eventually lead to vigorous green shoots appearing in the fertile volcanic ash. However, people don’t really think rationally about these things – their behaviour is dictated by how confident they feel and right now certainty is not available. Well, things will get better, but we have a ways to go yet.

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Bias In Action

Myopic Urges

The recent sharp correction in markets has clearly surprised a lot of investors. No doubt this is partly due to the standard myopia people seem to exhibit as soon as the last crash is out of sight, but it also seems to be connected to the fact that the seemingly inexorable rise in share prices and the continuing low interest rates on deposits has tempted new people into stocks. Faced, for the first time, with nasty losses they’re casting about for some kind of strategy to deal with the situation.

In truth if you need to find a strategy after markets have started falling it’s too late. For most of us the only sensible approach is to only buy things we’re comfortable holding through any kind of downturn and to then do nothing when volatility strikes. But even experienced investors face the urge to do something – anything – in the face of mounting losses. This is action bias, in action.

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Facing Down The Narrative Fallacy

Frenzy Time

Markets are tumbling. It's because the Fed is about to push up interest rates. Or maybe because the German economy is weak. Or perhaps it's Ebola, about to decimate global populations. Or it's geopolitical conflict – Ukraine, Syria, Iraq … take your pick. It's a perfect storm. Head for the hills and don't spare the horses. And remember the shotgun.

Of course, it's none of these. Markets are falling because they were a bit overpriced and investors were ignoring the fact because they'd got themselves into a typical feeding frenzy, ignoring the risk and ambiguity that are always present. Now that they have recognized the issue they're fighting each other to get out the door. Which is why all of the explanations for market weakness are entirely plausible and entirely wrong – they're an example of what Nassim Taleb calls "the narrative fallacy".

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HONTI #3: Don’t Fear Volatility

Rule #3: Don’t worry about short-term price trends, turn off the portfolio tracker.

Risk

"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances"; Ben Graham, The Intelligent Investor

Imagine if you could pick up the paper every morning and riffle through the pages until you get to the property section where, half way down the third column, you could find the current price of your own home. Imagine further that this price was set by a bunch of people you’ve never met making apparently random bets based on a combination of intuition, centralised economic statistics, a bunch of robots programmed by people with the social skills of a twig and, a couple of times a year, the real price achieved by one of your neighbours actually selling.

Welcome to the world of asset price volatility.

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Volatility, the Last Anomaly

Jitterbugging Markets

As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing.

Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.

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