It started out as a news story about cars, not investing: “When a Google self-driving car edged into the middle of a lane at just a bit over 3km/h on St Valentine’s Day and hit the side of a passing bus, it was a scrape heard around the world.”
The story has no connection with investing, until this twist: “The accident illustrates that computers and people make an imperfect combination on the roads. Robots are extremely good at following rules … but they are no better at divining how humans will behave than other humans are.”
Starting to sound familiar? It’s like the strange way financial markets sometimes react to news. Here’s the punch line: “Google’s car calculated that the bus would stop, while the bus driver thought the car would. Google plans to program its vehicles to more deeply understand the behaviour of bus drivers.”
Good luck with that one, Mr Google. How will you program the bus driver who is texting, or the one who drank too many beers last night, or the one who fought with his wife as he left for the bus depot?
Welcome to the world of investing and human behaviour, which is anything but rational.
Behavioural finance and the struggle for explanations
Human emotions make financial markets unpredictable. Common behaviours include:
- loss aversion – the desire to avoid the pain of loss
- anchoring – holding fast to past prices or decisions
- herding – the tendency to follow the crowd in bursts of optimism or pessimism
- availability bias – the most recent statistic or trend is the most relevant
- mental accounting – the value of money varies with the circumstance.
The unfortunate truth is that if an investor went to 10 different financial advisers, it’s likely he or she would end up with 10 different investment portfolios. Investors have their own views on issues such as diversification, risk, active funds versus passive funds, market efficiency, short term versus long term, etc. They often settle for ‘rules of thumb’ as a guide to investing.
The bestselling book, Nudge, by Professors Richard Thaler and Cass Sunstein, quotes the father of the modern portfolio theory and Nobel Laureate Harry Markowitz making a confession about his personal retirement account: “I should have computed the historic covariance of the asset classes and drawn an efficient frontier. Instead, I split my contributions fifty-fifty between bonds and equities.”
That’s it! One of the greatest investment minds of the 20th century simply goes 50/50. This is all the industry has achieved despite decades of research, complicated theories and multimillion-dollar salaries paid to the sharpest minds from the best universities.
Economics as a ‘social science’
Why is investing so imprecise, replete with emotions and strategies that have little supporting evidence, when other ‘sciences’ have unified theories? Why does a physicist know how gravity works, an arborist knows how a tree grows and a doctor can treat a patient with influenza, while fund managers around the world have different views on markets, stocks and bonds?
There is no scientific certainty in economics and investing. For example, we do not know precisely how the market will react when a central bank reduces interest rates. Maybe it happened because the economy is slowing, which is bad for stock markets. Or maybe lower rates will stimulate economic activity, which is good for stock markets. Nobody knows in advance.
Although economics pretends to be a ‘science’, it is a social science of politics, society, culture and human emotions. It is often said that economics suffers from ‘physics envy’. Economists cannot test a theory in a controlled laboratory-style experiment in the way a physicist or chemist can. Ironically, economists usually earn a lot more than physicists, and are called on as the experts in almost everything. Economists don’t even need empirical validation of their theories.
Which leaves markets prone to irrational bursts of optimism and pessimism. Morgan Stanley analyst Adam Parker recently advised clients: “If the consensus is right that we will chop up and down, then by the time we feel a little better, we should take off risk, not add some. Maybe you should do the opposite of what you think you should do. That’s the new risk management.”
That’s the advice! Do the opposite! Maybe it’s not as crazy as it sounds. Most people buy when the market is at its top because they feel confident and sell when the market is down. Empirical evidence is that investors usually underperform the index by poorly timing the market.
Let’s leave the final words to Jack Bogle, founder of the Vanguard Group: “The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in the business, I do not know of anyone who has done it successfully and consistently.”
Good luck with that, Google.
The scientists and engineers working on driverless cars probably Googled ‘human behaviour’ as they attempted to model how bus drivers might behave. They should study a good book on behavioural finance, as economists have struggled to understand human behaviour for decades.
Graham Hand is managing editor of leading financial newsletter Cuffelinks. He writes regularly on investing for YourLifeChoices. Cuffelinks will always be free for YourLifeChoices subscribers and includes insights from hundreds of market experts. You can register to receive the newsletter here. This article is general information not personal financial advice.
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