How to beat the market noise
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2017 has the potential to cause more political and stock-market upsets than the past 12 months, so how can investors avoid making mistakes amid the noise?
2017 is looking to be more eventful than ever. To help guide investors through the noise, we consider what the typical investor fears today and suggest how they can avoid worrying about the wrong things.
Starting in a simple manner, we asked investors to contemplate the following question: "What do you consider to be the biggest risks in 2017?"
A breakdown of the European Union, global debt levels, an ageing population, Donald Trump's Presidential policies and inflation were high on the list.
This outlines what we would consider to be one of the biggest flaws in intellectual investment thought. The problem with chasing such an analytical advantage in a future context is that you are playing in a world of prediction that propels you into several behavioural biases that are known to destroy wealth.
This is what risk analyst Nassim Taleb famously calls "Black Swan Theory". People have a great tendency in attempting to predict largely unknowable events, generally without success, and furthermore justify historical events after the event, adding little value.
The global financial crisis has only deepened this inclination as investors look around every corner for the next global recession.
Have you ever noticed the way you buy a car then realise you see the same car everywhere on the road? Conceptually, this is no different for investors.
Investors may not see something at first, yet once it is experienced they can't help but focus on the stories that are easiest to recall--such as the big market crashes--and then over-emphasise the likelihood of these events recurring when contemplating an investment decision.
An excellent piece of evidence to demonstrate this availability bias is in European banks. A mass exodus occurred in 2016 because the sector headlines had people fearing for a repeat of the banking crisis.
What they failed to comprehend is that a further 50 per cent plus loss becomes less probable when the downside is already priced in and a margin of safety exists.
This mental shortcut created a missed opportunity on the part of the average investor and was to their own detriment as prices rebounded higher in the latter part of 2016.
What did you fear a year ago?
Another means of demonstrating this "anti-prediction" concept is to re-consider the same question but rewind the clock just 12 months ago: "What did you consider to be the biggest risks or black swan events in 2016?"
Many people feared Brexit and a Donald Trump election victory, yet the markets rallied higher in the aftermath of these events. Many were also caught off-guard by the sudden losses in bond markets despite the perception of safety fixed income supposedly offers.
A quick look at the performance tables demonstrates the folly of making economic or political predictions as a means of obtaining a sustainable competitive advantage.
The lesson is that too many investors believe they have an analytical advantage by predicting what will happen. The more likely outcome is that they are using guesswork, and even if they are right, there is no guarantee their guesswork will prove profitable in a world of complexity and changing influences.
Whether it is this year, last year or 10 years ago, the same prediction problems always recur.
How can investors suppress the prediction urge?
Even after years of practice, it is humanly awkward to resist the urge of answering questions such as: "What do you think will happen after Brexit?"; "What will Donald Trump tweet next?"; or "Which celebrity will win the next reality TV show?"
The job of an investor is theoretically quite simple. First and foremost, you must determine whether you have a competitive edge that can be exploited and is likely to add value after any fees and taxes.
If the answer is likely to be yes, you need to be very clear on how this can be achieved on a sustainable and repeatable basis. A well-documented investment process will help articulate this, as even Warren Buffett asserts, "We enjoy the process far more than the proceeds."
How does that apply in today's market?
Most people recognise the US market is becoming more expensive according to most financial metrics. Yet, this isn't stopping investors from chasing yesterday's winner.
One such reason is likely due to the general consensus that the US is the "safest" economy and a natural place for investors escape to during times of distress. In reality, the vast majority of this is already priced in.
Second-level thinking requires us to understand which biases are at play, how much of this perception is priced in and whether a true margin of safety exists between the fundamental fair value and the current price.
We know markets are predisposed to the gravity of fundamental valuations, and behavioural deficiencies can push valuations abnormally to the upside and to the downside.
You need to make sure this isn't to your own detriment.
What is your competitive advantage in 2017?
This is a healthy reminder in a world of noise and fear-driven sentiment to focus on your strengths as an investor. By focusing on the long-term fundamental drivers of returns, you will never be the hero that picks the next crash.
However, if your ambition is to maximise the long-term creation of wealth in a risk-controlled manner, you should thoughtfully allocate assets towards long-term opportunities that offer compelling valuation benefits and a margin of safety.
If they don't exist, side-step and wait patiently. Find the best-in-class managers to fit the opportunity with the lowest fee possible. Acknowledge the danger of unknowable risk and build a robust risk framework to protect yourself against it.
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Dan Kemp is chief investment officer, EMEA, Morningstar Investment Management.
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