One of the great myths of investment is that success is predicated on being able to predict the future. While seldom expressed in these terms, this belief is nevertheless endemic in the professional investment industry.
Perhaps the most dangerous of the investment soothsayers is the over-confident market commentator who makes bold, short-term macroeconomic and market predictions with the oratorical skill of an Old Testament prophet and the success rate of an English middle order batsman.
Although such forecasters cause limited damage to investor returns in calm market conditions, they are dangerous during periods of market turmoil, as they tend to be conduits for the ‘whipsaw’ phenomenon.
This blight typically occurs when investors make fast, over-confident decisions in difficult market conditions and often leads to a permanent loss of capital.
The whipsaw mechanism will be embarrassingly familiar to many experienced investors. The process typically starts with a significant change in the price of an asset, and concern among those investors.
The void created by actual knowledge provides the perfect opening for commentators to make predictions about near-term price movements.
In most cases, these can be likened to a high stakes coin-toss – with other people’s capital wagered on the outcome.
Prices will do the opposite of that predicted roughly half of the time. This incurs sudden paper losses for the investor who has followed the forecaster. Having suffered further falls, the investor commonly loses confidence in the position (or the forecaster will change their narrative) and, consequently, the position is closed and the losses are crystallised.
A recent example would be investors who bought sterling on the back of predictions ahead of the EU referendum, only to reduce this position at a lower price in the panic that accompanied the Leave result. Those investors who then increased their sterling position as prices stabilised at a higher level realised a permanent loss of capital.
Given the known dangers of being whipsawed, it is reasonable to ask why experienced investors follow the siren song of over-confident forecasters.
The most likely answer is that the forecaster appeals to the natural human preference for action over inaction when faced with uncertainty.
This is most commonly described as the ‘fight or flight’ response. While the rush of adrenaline that accompanies this is ideal for extracting us from dangerous physical situations, it is counter-productive when estimating the outcome of investment choices.
To combat this adrenaline-fuelled response, investors need four things: clear principles that guide decision making and promote good investment behaviour; an investment process that encourages analysis; humility about the conclusions we reach; and an environment that allows investors to think independently and focus on the long-term benefits to the end client.
This tension between doing the right thing for investors and following the direction of the majority narrative was best described by the economist John Maynard Keynes, who wrote it is “better to fail conventionally than succeed unconventionally”.
