Are the best investors those who have the most accurate insight into the future? If so, can that insight be learned or is it a rare and elusive skill? These are important questions. If the answer to the first question is 'yes' and insight is innate rather than learnable, then past performance is, after all, an indicator of future performance – and if your star manager leaves, you will need to move your money.
Ability to forecast depends on both the potential that exists to generate insight into the future, and the ability of the investor to extract that insight. A recently published book, Superforecasting by scientist Philip Tetlock, can help us answer these questions and understand the extent to which investors are extracting insight or have crossed the boundary into illusion. He makes the crucial observation that predictability depends on what is being forecast, over what time frame and in what circumstances. For example, weather forecasts are fairly reliable a few days into the future, but predictability rapidly diminishes as time increases. And financial market outcomes over a matter of hours or days are relatively more predictable than over say one year. Generally, unpredictability increases with time, but not always. For financial markets, investor behaviour creates circumstances in which outcomes are more predictable over multiple years than over a single year. The propensity of financial markets to overshoot fair value for extended periods of time has been observed countless times across many markets. This is a key observation.
The most important questions for investment managers are firstly what are the sources and extent of their insight into the future; and secondly, what are they trying to achieve with that insight. For example, is it possible to reliably predict when a bull market or speculative bubble will end? While there is almost guaranteed to be a pundit who will have predicted each crisis, there is no evidence that this can be done with any reliability. That a bull market will end is predictable, but the timing is not. This creates a conundrum for investors – do they position for the inevitable or ride the wave? There is no easy answer to this. But typically, many investors do not perceive the dilemma because behavioural and perception biases underlie periods of market irrationality. Misperception, extrapolation of past trends, and an apparent ability to rationalise anything on the part of investors, create these market divergences and make rational investors appear irrational. Relatively long periods of irrationality are a clear demonstration that investors, like everyone else, are vulnerable to illusion. They can be seduced into believing that they know more than they really do and believing the wrong things.
Psychologists explain misperception as being a consequence of the way we all think which involves the product of two systems: first, automatic perception and understanding; and second, conscious thought - which may or may not override the first system. In Tetlock's book he poses the question: if a bat and ball cost $1.10 and the bat costs $1 more than the ball, what does the bat cost? System one's intuitive non-thinking answer is typically $1; which on reflection your system two will then tell you is incorrect. The reliability of intuition depends on the extent of relevant experience, but your mind will jump to conclusions on the basis of thin air. And even where someone has a wealth of experience, the future is never entirely a reflection of the past, so it's always important to try to identify what part of past patterns won't fit the future. No doubt system one has served an important evolutionary role and works well in many circumstances, but it mostly does not provide a sound basis for investment even by experienced investors. How can you tell whether your investment manager is too reliant on system one for decision making? One simple indicator is to find out how confident they are in their perspective on the future – high levels of confidence are suggestive of a lack of in-depth thinking. Even a well-defined coherent confident story can provide more entertainment than insight.
Genuine insight into the future requires that investors are open-minded and curious, they must be seekers of truth (not entertainment), and sceptical – particularly of the extent of their own insight – always seeking to uncover what remains to be known. And when they talk about the future, the best investors tend to focus on the risks and uncertainties, and they will talk about the ways to hedge positioning so that regardless of what markets deliver, investment outcomes are as robust as possible. And in judging investment outcomes, it is important to remember that rational insightful investors can look wrong for extended periods of time. As the renowned economist Rudiger Dornbusch famously and insightfully said: "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought".
At MLC we understand that the future is always uncertain and that forecasts of the future are always unreliable. Genuine insight requires that we remain sceptical, that we focus on understanding the possibilities, and always seek to uncover what remains to be known. We believe these are the keys to seeking the returns that investors are looking for.
This document is issued by MLC Investments Limited (ABN 30 002 641 661, AFSL 230705) (MLC), a subsidiary of NAB Asset Management Limited ABN 16 134 158 517. NAB Asset Management is the investment management business of the National Australia Bank Limited ABN 12 004 044 937 (NAB) group of companies (NAB Group).105–153 Miller Street, North Sydney 2060.
This information may constitute general advice. It has been prepared without taking account of an investor's objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs. Any opinions expressed in this document constitute our judgement at the time of issue and are subject to change. We believe that the information contained in this communication is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made as at the time of compilation. However, no warranty is made as to the accuracy or reliability of this information (which may change without notice).
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Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.
MLC relies on third parties to provide certain information and is not responsible for its accuracy. MLC is not liable for any loss arising from any person relying on information provided by third parties. Any forecast or forward looking statement in this document is provided for information purposes only. No representation is made as to the accuracy or reasonableness of any such forecast or statement or that it will be met. Actual events may vary materially.
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