28 February 2017
Despite a highly unpredictable investment environment, share market returns have remained strong. What’s behind this paradox?
Contrary to most expectations, share markets moved higher in the December quarter after the election of President Trump. Investors focused on the potential positives of the Trump regime: tax cuts, fiscal stimulus and the reduced regulation. Most were apparently ignoring the risks, which include rising government debt, increased protectionism, trade barriers, and more generally, the propensity for erratic and disruptive policy making. Only more recently have some doubts started to creep in.
While the risks seem clear, why has market pricing ignored them? The answer is that in the short term, share prices often don’t reflect changes in the underlying fundamentals.
In the short term, the share market acts like a voting machine – it reflects how investors feel rather than the true value of listed companies. It’s only over the medium to longer term that the share prices properly weigh the fundamental drivers of share prices. So the market rallied with Trump’s election; then early on it began to look more nervous and looked like starting to price in some of those risks. But that halted when President Trump tempted markets with a ‘phenomenal’ tax plan.
What’s driving the market is perception and emotion: sequences of either positive or negative news periodically tip investor psychology between optimism and fear.
The trouble with emotional decision making is that it overrides objective assessment of the underlying fundamental drivers of an investment. To make sound investment decisions, we need to objectively weigh both positives and negatives - even when all appears to be well on the surface. We need to weigh all the potential future risks against the potential upside.
But as investors, properly considering future risks is difficult. It goes against common emotional biases. For example, the future seems obvious – but only once it has become the past. ‘Hindsight bias’ is the tendency to assume that what happened in the past was inevitable. That belief in the inevitability of the past encourages investors to think that they should have been able to forecast it, and that therefore they can forecast the future. But of course the past is just one of a large number of possibilities that might have occurred, and the future can’t be forecast.
Hindsight bias makes us too grounded in what’s happening now. It makes it difficult to envisage a world that’s significantly different from today, and from what’s generally expected to happen. Before the global financial crisis, hindsight bias created the illusion that we were in a low risk world, although it was clear at the time that risk was high. And today, although US inflation is rising, expectations are for stable inflation ahead and only limited interest rate rises are envisaged.
Unlikely outcomes do happen: after all, a year ago, the election of Mr Trump was seen as a remote possibility. The environment can change and at times it can change quite suddenly. So investors always need to consider a range of possible futures and not rule out events that are currently unexpected. And it’s important to remember that short-term market movements don’t provide an accurate reflection of current market risk or future opportunity.
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