Q2 2019 Newsletter
Amid tariff wars and temporary truces, Brexit bewilderment and historic Hong Kong rallies, the global thermometer isn’t the only gauge that may leave you and your investment temperament reeling between cooling chills and hot thrills this summer.
Let’s take a refreshing journey back to May 2018, when the CFA Institute hosted its 71st Annual Conference in (of all places) Hong Kong. It’s also where Nobel Laureate and behavioral economist Daniel Kahneman presented how to improve on decisions by tuning out the “noise.”
You probably already agree it makes sense to ignore noisy distractions in pursuit of your financial goals. But how do you know what is noise and what is substance?
Kahneman and his research partners offer us important insights on this front. In an October 2016 Harvard Business Review article, they define noise as how widely different people’s interpretations of the exact same information tends to vary. When judgments based on the same data vary by a lot, they’re considered noisy … because how do you know who’s right?
For example, as reported in the HBR article, Kahneman and colleagues measured the noise levels at two financial service organizations by presenting identical case studies to multiple participants at each firm. The firms’ executives predicted judgments might vary 5%–10% of the time. Instead, on average, different professionals’ judgments varied between 48%–60% of the time.
This outcome is not exclusive to financial types. Kahneman found similar results across doctors, judges, loan officers, and other professionals. Bottom line, even educated judgments can be very “noisy,” and that’s before we even consider the din of discussion we’re subjected to daily from a never-ending global feed of often insignificant information.
As Kahneman describes, “The problem is that humans are unreliable decision makers; their judgments are strongly influenced by irrelevant factors, such as their current mood, the time since their last meal, and the weather. … Whenever there is judgment there is noise and probably a lot more than you think.”
Let’s bring this back to investing. Does this mean everything you hear is noise, and nobody knows what’s going on? In terms of breaking news, it probably does. That’s why it’s all the more important to heed the tips Kahneman shared with CFA conference attendees:
- Be disciplined. Kahneman refers to using algorithms, or evidence-based rules, for quieter, more consistent outcomes. Following such rules may not deliver as hoped for every time, but it should outperform excessive judgments (even from the “experts”).
- Think big-picture. Kahneman suggests: “See the decision as a member of a class of decisions that you’ll probably have to take.” This includes avoiding regret over past outcomes as “probably the greatest enemy of good decision making in personal finance.”
- Be open to noise-dampening advice. Seek advice that helps you tune out rather than amplify judgmental noise. As Kahneman describes, a good advisor is a “person who likes you and doesn’t care about your feelings.”
Okay, maybe we do care about your feelings a little bit. For example, if you’re feeling the heat from this summer’s unfolding news, we hope you’ll be in touch with your questions or concerns. We’ll help you separate the sound from the substance.
DHG Wealth Advisors
Equity markets around the globe posted positive returns for the quarter. Looking at broad market indices, US equities outperformed non-US developed and emerging markets during the quarter.
Value stocks outperformed growth stocks in emerging markets but underperformed in developed markets, including the US. Small caps underperformed large caps in all regions.
REIT indices underperformed equity market indices in both the US and non-US developed markets.
Timing Isn’t Everything
With the popular US market averages hitting new highs this summer, it’s not unusual for the stock market to be a topic of conversation at barbeques or other social gatherings.
A neighbor or relative might ask about which investments are good at the moment. The lure of getting in at the right time or avoiding the next downturn may tempt even disciplined, long-term investors. The reality of successfully timing markets, however, isn’t as straightforward as it sounds.
OUTGUESSING THE MARKET IS DIFFICULT
Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with substantial challenges. First and foremost, markets are fiercely competitive and adept at processing information. During 2018, a daily average of $462.8 billion in equity trading took place around the world.1 The combined effect of all this buying and selling is that available information, from economic data to investor preferences and so on, is quickly incorporated into market prices. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time an investor can react to it.
Dimensional recently studied the performance of actively managed mutual funds and found that even professional investors have difficulty beating the market: over the last 20 years, 77% of equity funds and 92% of fixed income funds failed to survive and outperform their benchmarks after costs. 2
Further complicating matters, for investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice. Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional:
“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.”
TIME AND THE MARKET
The S&P 500 Index has logged an incredible decade. Should this result impact investors’ allocations to equities? Exhibit 1 suggests that new market highs have not been a harbinger of negative returns to come. The S&P 500 went on to provide positive average annualized returns over one, three, and five years following new market highs.
Outguessing markets is more difficult than many investors might think. While favorable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors. The positive news is that investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on the things they can control (like having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes) investors can better position themselves to make the most of what capital markets have to offer.
1. In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Daily averages were computed by calculating the trading volume of each stock daily as the closing price multiplied by shares traded that day. All such trading volume is summed up and divided by 252 as an approximate number of annual trading days.
2. Mutual Fund Landscape 2019.
The content in this newsletter is for informational purposes only and does not constitute investment advice or an offer to buy or sell any security. The information in this newsletter is believed to be accurate as of the time it is distributed and may become inaccurate or outdated with the passage of time. You should contact your financial advisor or CPA professional before making any tax or investment-related decision. Past performance does not guarantee future results. All investments may lose money.