Complex world, simple rules, no clutter

How can we explain why the stock market behaves as it does?  Perhaps it is so complex that it is beyond a useful plain English explanation.

 

If that is the case, as I will argue, how can any of us expect to have any useful insight such that you can achieve superior investment returns. Most importantly for us, how should this inform the FundExpert offering?

 

The background to this discussion is illuminated by one of the few incontrovertible facts – a long term record of failure by most investors, including fund managers. For example, 94% of fund managers cannot consistently beat an undemanding benchmark. (See Vintage Report 2021)

 

These thoughts, and many more, crossed the mind of myself and the team as we reviewed the progress on our website redesign, in particular how to accommodate the many splendid ideas from Gold Members. 

 

It comes to this. Our whole ethos is built on simple rules midst complexity. That simplicity will be reflected even better in the new design. But how dogmatic should we be? Is it our way or no way? To answer this means revisiting some fundamentals.

 

Let’s start with the first question and build from there…

 

 

At its simplest, the stock market moves from day to day, month to month, year to year, and is dependent on the balance of buyers and sellers. More buyers, and it goes up; more sellers and it goes down.

 

But this gives no insight as to how we should invest. We need more.

 

The Efficient Market Hypothesis, proclaimed by Eugene Fama back in 1970, says it is all very simple. All investors are rational, they have access to the same information at the same time, and therefore no investor has an edge. This means everyone should do nothing other than buy index trackers. 

 

But this simplistic theory is complete hokum. It bears no resemblance at all to what goes on in the stock market, so has no practical value to an investor who wants something more than mediocrity.

 

 

There are millions of investors. They act at different times, over various timescales, with different objectives, wide ranging attitudes to risk, and with vastly different sums of money. 

 

The information on which they individually act is many and various – facts, assumptions, research, expert comment, numerous theories, assumed correlations, rumour, proclamation, groupthink, instinct, and some hocus pocus. Many of these components are not directly linked to the stock market at all, but assume some relationship of cause and effect with the stock market.

 

Take the assumption of some that the stock market is driven by inflation. Putting to one side that this crowd cannot precisely agree on how inflation moves the stock market, the debate on inflation itself is extremely conflicted. This begins with there being no agreed definition, after which you get into the long grass, of which the word cloud below gives you a sense. This is just one of the scores of such word clouds which we could create around other components which may (or may not) explain stock market behaviour.

 

That highlights this complex world in two ways:

 

Firstly, the dense jungle of factors that drive the market's behaviour.

Secondly, there are no clear linear relationships, no simple formulas. Put another way, there are no clear paths through that dense jungle.

 

 

 

The most common investor mistake is to analyse a single component, like inflation, and use it to explain the entire system. This kind of analysis is not just unhelpful but also dangerous, as we develop a naive understanding of cause and effect, and are particularly caught out at big turning points.

 

There is just no way we can model the vast complexity and interactions of the stock market.

 

Once you know this, it should stop you listening to and acting upon market forecasts by a wide range of experts – remember the 94% failure rate.

 

The stock market is what is called a complex adaptive system. This means that even the deepest understanding of one component of the system doesn’t mean that we understand the system as a whole.

 

By its nature, it cannot be modelled in a way that will enable consistently accurate forecasts. This is not just because of the complexity. It is also because the market participants keep adjusting their behaviour in unpredictable ways – they keep adapting their behaviour.

 

If investors insist on trying to understand the causes for market moves in simple cause-and-effect ways, and trying to predict, they will continue to be disappointed with their results - remember the 94%.

 

 

The simple answer is that, although it is a good explanation of why the market behaves as it does, it doesn’t provide the certainty and simplicity which we crave.

 

Our inbuilt human desire to understand, demands those simple explanations. When we experience uncertainty, we want simple answers, not complex ones.

 

This means the investment industry feeds us and the media with simple solutions – but they are of absolutely no value in guiding our investing, and are typically a fatal distraction.

 

With all of this complexity you have three options for your investing:

 

Only one of these plays into our evolutionary strengths…

 

 

The evolution of our brains reflects the complexity of the world we have inhabited since year dot, in particular the constant threats and uncertainty. That is why our brain has developed shortcuts, which don’t just save time and energy, they ensure survival. These mental shortcuts are simple rules, and they are also unconscious.

 

My favourite example from Clueless is the snake in the glass case.

 

Our brains are designed to maximise our chances of survival as the world existed 50-200,000 years ago.

 

Our brain, let’s call it our old brain, learnt to take short cuts, which meant it could respond rapidly to threats and improve the odds of survival. It is fast, a “quick and dirty” system, which enables your brain to take shortcuts with very limited information.

 

This is my favourite example of the old brain in action:

 

That is your old brain in action. It will react to keep you safe – even though the snake is behind a glass barrier.

 

When the snake moved TWO signals were sent to your brain:

 

There is a threat, and uncertainty, and the old brain jumps into action rapidly, and forces the body to move backwards rapidly – without hesitation.

 

In contrast, the signal that went more slowly, to what we might call the new brain, processed the information more consciously and recognised that there was a layer of glass between you and the snake. The new brain is more rational, but slow.

 

But the signal from the new brain of no threat was too late, you had already jumped backwards.

 

From a survival point of view, if you had been on the savannah thousands of years ago (without the benefit of the layer of glass) this old brain function is fast and effective and would have saved your life. You would have died if you relied on the (slow) new brain to figure what to do.

 

 

The important investment takeaway is that in a complex world, simple rules can work most of the time – the evolution of our brain highlights this, as does the very survival of humankind to this point.

 

 

Of the three options for investing set out above, a complex solution, option 2, will be difficult to consistently apply, be understood by few, and cumbersome to adjust with so many moving parts. 

 

For example, the US stock market gained 97% in the ten years ending February 2016. In contrast, the average equity hedge fund, actually lost 6%. The latter is a great example of what happens when you try and apply complex solutions in a complex environment.

 

In contrast, if you take the evolutionary hint, option 3 is more likely to succeed – a simple solution and simple rules.

 

Simple rules mean we focus our attention. They mean less mental stress, and acting faster.

 

We can ignore the rest of the complexity, the distractions, which otherwise tends to overwhelm our decision-making.

 

 

OK, so we need a simple solution or rule, or a small number of rules. But how do we arrive at these if the stock market is so complex, and so fluid? We observe.

 

And Nobel Prize Winner Eugene Fama did just that. You will recall from earlier that he believed it is all very simple. All investors are rational, they have access to the same information at the same time, and therefore no investor has an edge. This means everyone should do nothing other than buy index trackers – but he was wrong, Noble Prize or not.

 

His thinking “evolved” over the years – which is code for accepting that his original analysis was flawed.

 

By 2014, not only did he accept that there were exceptional strategies that could consistently deliver above average returns, but that “all models that do not include a momentum factor fare poorly”. 

 

Momentum is Dynamic Fund Ratings, a rule for selecting funds based on the simple observation that the most effective investment strategy is to “buy winners”.

 

 

There is always a “but”. 

 

All of that complexity… that’s us! To a considerable extent, the complexity of markets is derived from us as individuals.

 

And those mental shortcuts which our brains have cleverly developed over tens of thousands of years, have ensured our survival as a race – but they are a bloody nuisance when it comes to investing. That this is the case was recognised by another couple of Nobel Prize winners, Richard Thaler in 2017 and Daniel Kahneman in 2002.

 

We are very good at following unconscious mental shortcuts. But we are terrible at following conscious rules, like applying Dynamic Ratings, when they clash with those unconscious shortcuts.

 

You can see examples of this in 5 Deadly Sins and 19 Bad habits Costing You Fortunes.

 

 

We must not try and be all things to all people. There are clear and simple rules which will guide your investment success, and we must make it as easy as possible for you to apply these rules.

 

A key part of the latter is keeping clutter to a minimum. We must limit distractions on the site, and do our best to keep Gold Members focussed on the rules and the prize. 

 

We must also make sure that our tools to prod and prompt and alert are as good as they can reasonably be, but also relevant.

 

Lastly make sure our communications are helpful in the context of both those simple solutions, and the biases that we all have. This applies to the Friday note and teleconferences, and also facilitating the sense of community via the Facebook group.

 

That was a long conversation. I hope it has been useful by giving you a sense of the way your FundExpert team are thinking.