Market behaviour can be extremely erratic which can create a huge amount of uncertainty when predicting the future. In this insight, Lewis Grant, Global Equities Senior Portfolio Manager at Hermes Investment Management, explains why he therefore favours a consistent, boring approach over one that is fuelled by sentiment and hype.
Excitement in investment is rarely a good thing. It can create hype which in turn can lead to irrational behaviour. If we take Bitcoin as an example, hype around investment in the cryptocurrency drove the asset class to grow at a phenomenal rate and for a while, this sentiment-led growth may have left investors feeling excited about potential returns. Price momentum can act as an incredibly effective investment signal but it can also be a dangerous one. We believe it is important to remain emotionally unbiased as euphoria should not be the goal of investing.
That is not to say such hyper-growth investments need to be avoided altogether, but instead understood in a risk controlled portfolio and as part of a disciplined, diversified approach.
No Magic 8 Ball in investing
On any given day news outlets produce up-to-the-minute explanations of market movements. Fuelled by an insatiable demand for real time, knee-jerk comments, these outlets are expected to analyse the impact of seemingly small macro events on markets and report live reactions. But given how unpredictable these impacts can be, the market movements recorded can often be erratic and little more than noise, frequently reversing even within the same day.
These headline reversals demonstrate how hard it is to be certain when explaining the market even after the fact. Books continue to be written about the Global Financial Crisis and the market’s reaction – surely by now such an event should be understood? Given how difficult it seems to be to explain the market’s behaviour ex-post, consider how hard it is to predict the market’s behaviour ex-ante.
There is a huge amount of uncertainty in predictions, and investors need to factor this in to their portfolio construction process. Market behaviour is incredibly erratic – style drivers in the market change rapidly, investor sentiment can reverse for seemingly no reason, unanticipated tweets from world leaders can send the VIX spiking without warning. Diversification can help to insulate a portfolio against these unpredictable externalities.
Seeing the full picture
Even when looking at an individual company there will be many unknowable influences on its future prospects. Consider investing like trying to forecast the winner of the F1 Grand Prix. Mechanical and engineering knowledge could be applied to assess the ability of the car’s engine, tyres etc. just as we would use our accounting knowledge to assess the state of a company’s financial statements. The competence of the driver, in terms of skill and experience, would be considered as well as their ongoing control of the vehicle, like that of the senior management driving the strategy of a company. But can we as spectators truly observe all these variables and have a full understanding of how a company is functioning?
As an outsider to racing, we may see the high-speed glamour of the competition on the surface, but what we won’t see is the work of a multi-national team striving to be at the cutting edge of science, engineering, design and logistics and the challenges they face along the way. We can never truly know what is going on inside the enterprise. There are certainly things we can do as investors, such as engaging with companies to promote the best standards of corporate governance to minimise risks, but is it naïve to think we could ever fully know the inner workings?
There are many influences on a company’s future, only some of which could ever be predicted. Too many portfolio managers underestimate the amount of uncertainty and consequently overestimate their ability to make accurate predictions. This encourages overly concentrated portfolios where the true driver of performance becomes noise rather than the portfolio manager’s skill.
Consistency is key
Diversifying the portfolio and prioritising the consistency of short-term outperformance does not prevent investors from generating significant long-term gains. The power of compound interest can turn a small steady gain in to much larger and more exciting returns. And yet investors frequently favour higher risk portfolios, failing to recognise the damage that volatility can do to compounded returns. An investment that falls by 50% in value will subsequently need to double simple to restore the investor to parity. Likewise a portfolio that underperforms by 10% needs to subsequently outperform by 11.1% to return to break even. Volatility can significantly hurt the accumulation of an investor’s wealth.
An investment offering consistency also removes an element of timing from an investor’s decision-making process. When making an active equity investment an all-weather approach which can generate alpha in any market environment is a good investment at any time, whereas even professional investors have proven unable to reliably predict the forthcoming market environment.
Consistency also provides investors with comfort – they know what to expect from the portfolio and are more easily able to judge what we are delivering for them. Even long-term investors care about the short term, and many lose their long-term focus when their investments fail to behave in the short- to medium-term. This may be a boring approach for investors seeking the next hot game-changing company, but it is an approach that allows our investors to sleep easy at night.
Planning for the unknown
Predicting the market is inherently difficult, but it is not impossible. We just need to be honest about the degree of uncertainty in our predictions and structure our portfolios appropriately. It is perhaps a key message that many may not wish to discuss, but the accuracy of most portfolio managers’ forecasts is low. But that’s ok – with the correct structure and appropriate diversification even a small degree of accuracy is sufficient to generate meaningful outperformance.
The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.