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You can either accept that there is a lot of randomness in the equity markets, or you can hunt for deep reasons behind every reaction and overreaction


So the equity markets are down a lot over the last few days. I'm quite amazed at how, after years and decades of seeing big moves on the equity markets, so many of us still find the fear and/or the enthusiasm to react as if there is some valuable information content in these gyrations.

The daily spikes and troughs of the stock markets over the recent months and days have seen a lot of people hunt for cause and effect. The steady rise over a period, as well as the sudden downturn and then the recent daily shocks has as many different sets of reasons behind them as there are talking heads in the business media and investment analysis business.

Which is fine, everyone is entitled to an opinion, specially if it's their profession. But there's actually a problem, which is that everyone is united in the belief that there are clear and identifiable reasons for everything that is happening. There is a reasonable story--actually, many reasonable stories--about why the equities markets are doing what they are doing. However, for most analysts, there is a narrative that gets built every morning and every evening explaining what happened and what is about to happen.

Many investors too seem to believe in this whole system. They think events happen, and the equity markets respond to in a precisely identifiable way to those events. In this way of thinking, every move can be connected to a cause. It's actually unfair to blame just the business media for it. Finding patterns and believing in cause and effect is an integral part of the human psychology. As a species, we have probably survived and flourished by figuring out how the world works, and being able to anticipate what would happen in the near future. For example, ancient human beings wouldn't have survived if they hadn't associated eating food that smells rotten with falling sick. Figuring out cause and effect is central to dealing with the world.

But it's easy to take this too far. Most superstitions are based on seeing too much associations with random events. A black cat crossed your path? Well, there are millions of black cats in the world and they are constantly running around crossing people's paths. Some of these people will randomly have bad things happening to them, thereby strengthening the belief in the superstition.

Much of what we believe about investments comes in this category. Someone is managing a mutual fund and takes certain actions. The fund does well. Immediately, we conclude that the fund performed well because of that fund manager's actions. Ergo, he must be a good fund manager, and will continue to do so in the future. But this conclusion may not be correct--we have been fooled. We have been 'fooled by randomness'.

Of course, that's the title of this great book that Nassem Nicholas Taleb wrote more than a decade ago. Taleb's book should be compulsory reading for every investor and fund manager. However, apart from ritual references to 'black swans', which was the idea behind his later book, no investor or commentator pays much attention to the real idea here. Most of what happens in the markets is random. We pick up patterns in this randomness and try to draw inferences and make predictions. Those work sporadically when we get lucky, but instead of recognising randomness, we think something has succeeded. The central idea here is that there is a lot of randomness in investing and if you try to analyse everything with the assumption that it is not random, then you will not be able to understand what is going on and how to cope with it.

The only way to cope with this is to understand that beneath the randomness, there are patterns but they manifest themselves over long periods of time, driven by fundamental attributes.

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