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The two most dangerous words in investing

For anyone interested in investor behaviour, extremes matter. When there is a severe dislocation between the value of an asset and its fundamental characteristics, or spells of dramatic price performance, it suggests that some of the most powerful aspects of group psychology are taking hold. Such situations create both significant risks and opportunities. The problem is that identifying extremes is much harder than it seems. There are, however, a couple of words than can help – ‘always’ and ‘never’.

Market extremes are obvious, but unfortunately only obvious after the event. Once the extreme has been extinguished, we can happily carry out a post-mortem on the irrationality that led to it, typically ignoring the fact that for the extreme to have existed many people must have considered it to be justified at the time.

And, of course, this must be the case. For market extremes to be reached there has to be a belief that the levels of exuberance or dismay surrounding a particular asset class is simply a sensible response to a changing world. The performance and persuasive narratives that accompany financial market extremes are taken not as the cause of it, but as evidence for its validity.

This creates a problem for investors. Periods of extremes are critical and come with major behavioural risks, but we struggle to identify or acknowledge them in the moment. What can we do about it?

As usual, there is a heuristic that can help. Perhaps the most reliable indicator that sections of financial markets are exhibiting extremes in sentiment or valuation is when investors start to use the words ‘always’ and ‘never’. The more we hear these uttered, the more we should pay attention.

The problem with the words ‘always’ and ‘never’ in an investing context is that they suggest a certainty that simply does not exist in the complex and chaotic world of financial markets.

Whenever we fall into the trap of saying something ‘always’ or ‘never’ happens, we can be sure that a performance pattern has persisted for so long that we have become unable to see anything else in the future: “The US will always outperform”, “yields will never rise” etc…

‘Always’ and ‘never’ are reflections of two ingrained and influential investor behaviours – extrapolation and overconfidence. Prolonged trends often become perceived as inevitabilities.

At the point we have decided that nothing different can occur, valuations have undoubtedly already adjusted to erroneously reflect a level of certainty in inherently uncertain things.

Thinking in terms of ‘always’ and ‘never’ has profound consequences for investors, particularly in terms of how we build portfolios. The more certain we are about the future and the more confident we are in the prospects for a particular security or asset class, the less-well diversified we will be. Portfolios built on the idea that things ‘always’ happen or will ‘never’ happen are probably carrying too much risk. Market extremes inescapably encourage dangerous levels of concentration and hubris.

Of course, there are things in financial markets that we can be more sure of than others. Saying that technology stocks ‘always’ outperform is very different to claiming that equity markets ‘always’ produce positive returns over the long run. Neither of these statements are true, but one is inherently more problematic than the other.

What investors really need to be wary of is situations where there is an evident gap between the level of certainty we can possibly have in how the future will unfold, and the certainty with which we talk about it. When that gap is wide it ‘always’ ends badly.

 

Joe Wiggins is Director of Research at UK wealth manager, St James’s Place and publisher of investment insights through a behavioural science lens at www.behaviouralinvestment.com. His book The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions.

This article was originally published on Joe’s website, Behavioural Investment, and is reproduced with permission.

 

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