Ignoring The Noise (Market Review) written by John Husselbee, Portfolio Manager
As an industry, investment is certainly not short of data; the challenge can come when interpreting that information as so many of us fall into the traditional behavioural traps.
There is a basic equation about creating panic that goes as follows: high stakes plus major events where the causes are confusing or unknown can lead to some irrational behaviour, even among the supposedly smartest people.
In recent months, we have seen plenty of this with fears around Brexit and trade wars repeatedly pushing investors into decisions that could be potentially detrimental to their long-term wealth. Political volatility has contributed to this environment, with this panic mode spreading across the supposed governing class in recent months.
In forming his government, Boris Johnson dismissed 11 senior ministers and accepted the resignations of six others – described by MP Nigel Evans as “not so much a reshuffle as a summer’s day massacre”. The mass dismissal was the most extensive Cabinet reorganisation without a change in ruling party in post-war Britain, exceeding the seven Cabinet ministers dismissed in Harold Macmillan’s ‘Night of the Long Knives’ in 1962.
Meanwhile, in the 2017 to 2022 Parliament (so far), more than 50 MPs have changed party affiliation (with several switching more than once), either voluntarily or through expulsion. That compares to just six in New Labour’s first term in office from 1997 to 2001 and 18 during its controversial second term, a period that included the Second Gulf war and its aftermath.
Before looking at what this febrile environment means for investors, it is worth recognising this behaviour is littered through human history (with a tip of the hat here to US commentator Morgan Housel). Take a trip back to early sixteenth century London for example, where we can see this panic equation in full effect.
In the 1520s, the major astrologers of the day were predicting a huge flood would engulf London, based on something known as the Grand Conjunction, when all the planets would align and cause huge tides. They had an exact date for this – 1 February 1524 – and this led to a huge exodus from the city, largely those with the financial capacity to do so, with figures showing a drop in the population from 120,000 in 1523 to 80,000 the following year.
As we know, this flood never materialised, highlighting the panicked behaviour that can come from misinterpreting data. There have been significant floods in the capital in the subsequent centuries however, most recently in 1928 and 1953, leading to the introduction of the Thames Barrier in Woolwich in 1982. Since then, the barrier has been in frequent use, closing more than 50 times in 2013-14 for example, and we would see this as a strong example of risk management. Prepare for all conditions with a well-diversified portfolio rather than panicking and running for the hills at the first sign of troubling data.
A couple more examples add some gloss. Few of you, I suspect, will have heard of Archibald Hill, a pioneering physiologist who won a Nobel prize for his work on the production of heat and mechanical work in muscles. Hill’s work with professional athletes worked out exactly how fast each one could run based on their physiology but ultimately proved an ineffective predictor of success on the track as it fails to take the emotional side of competition into account.
A similar story can be read across to investment when attempting to work out future equity market returns. Calculating returns requires three basic elements and two of these are easily accessible in the shape of dividend yield and earnings growth. The problem comes with the third of the trio, change in valuation, as this is where sentiment and the proverbial animal spirits come into play.
Another name few people are likely to have heard of is Hungarian mathematician Abraham Wald, another figure who highlighted the importance of looking at data in different ways. Part of the Statistical Research Group at Columbia University during the Second World War, Wald was among those asked to find ways to minimise bomber losses to enemy fire.
Officers came to Wald with what they felt was useful information – most of the bullet holes were in the fuselage and very few in the engines so surely extra armour should be concentrated on this area of greatest need where the planes were getting hit the most. Wald turned this on its head and said that in fact, the extra armour should not go where the bullet holes are but where they are missing: on the engines.
His insight was to ask where the missing holes were – and the answer was on the missing planes. The reason planes were coming back with fewer hits to the engine is that those taking damage in that area were not getting back at all: the large number returning with a bullet-riddled fuselage was strong evidence that hits to this part of the plane could (and therefore should) be tolerated.
What all these stories show is the dangers of misinterpreting data and we continue to warn against in the increasingly short-termist mindset of many investors. One of our key roles as a multi-asset manager is sifting through the masses of data produced by the investment industry to find a core of managers we believe can add long-term value – and we continue to repeat the message that focusing too much on short-term performance numbers and persistency of returns can lead to major mistakes.
As we wrote in a recent piece, recent data from Morningstar showed that from 1926 to 2018, US stocks owed all their outperformance to just 51 months, or less than 5% – and if investors had owned those companies for all 1,063 months apart from those 51, they would have failed to beat cash.
Even for the very best funds – the top 10% of all those that beat their benchmarks over 15 years to the end of October 2018 – the outperformance was due to just 16 months of excess returns, one year and four months out of 15 years.
For us, this continues to stress the important of our mantra than consistency of performance is impossible for fund managers but consistency of process is essential. Focusing on the wrong data or misinterpreting the growing amount of market noise can send investors running for the hills in fear of a flood while we continue to ignore the noise as much as possible and stay invested.
Key Risks & Disclaimer: Pennine Wealth Solutions LLP (2 Buckshaw Court, East Terrace Business Park, Euxton Lane, Euxton, PR7 6TB), authorised and regulated in the UK by the Financial Conduct Authority and is for professional investors only. These investments are only accessed via accredited Financial Advisers. Content written by John Husselbee Head of Multi-Asset at Liontrust Ltd.
Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.
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