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Consistency is overrated
What is the better investment approach? To be approximately right or consistent and wrong? Ok, when put this way, everybody would say that consistency is overrated. Yet, consistency is a quality that we all value both in life and in our investment decisions, even though financial markets aren’t necessarily consistent.
Here is a challenge for you: On any given day, rank the performance of different equity sectors and try to make sense of the ranking. On some days, it will be easy, with defensive sectors outperforming cyclical sectors or the other way round. But most days, the performance ranking will be an odd mix that defies simple explanations. Yet, journalists have to come up with a story of what drove markets that day, so they have to tell a story around these rather inconsistent daily returns.
Clearly, daily market returns are mostly noise, but what about the current disconnect between inflation-linked bonds and the inflation they price in vs. the inflation warnings of people like Larry Summers? Equity markets have been worried about runaway inflation for most of the first half of 2022, yet 10-year breakeven inflation in the US never rose above 3%, and the 5Y5Y breakeven inflation – the market’s expectation of 5-year average inflation in 5 years – never rose above 2.8%. How can equity markets freak out about persistent inflation while bond markets say there will be no inflation problem?
This kind of inconsistency between equity and bond markets happens all the time. Different assets tend to have different investor communities and these investor communities interpret things differently.
Yet, if you confront investors with these inconsistencies, they prefer to resolve them by changing their choices and ‘stories’ to make them consistent rather than accepting the inconsistencies as a fact of life.
Kirby Nielsen and John Rehbeck published an interesting study that tested what happened when some fundamental axioms of decision-making are violated. One of the axioms they tested was consistency. I am simplifying their study but in essence, they asked people to participate in two lotteries.
A: 50% chance of winning $3 and 50% chance of winning $15
B: 25% chance of winning $5 and 75% chance of winning $12
A’: 50% chance of winning $5 and 50% chance of winning $10
B’: 30% chance of winning $0 and 70% chance of winning $15
Note that in both lotteries, the second choice has a higher expected return than the first choice. So, a consistent participant would choose the second option in both lotteries.
And here comes the interesting bit. Some participants did make inconsistent choices in these lotteries. For example, they chose option B in the first lottery but option A’ in the second lottery. Why? Because in option A’ you make at least a small gain, even if your expected gain is smaller than in option B’ where the negative outcome means gaining nothing.
This behaviour is perfectly rational for an investor who is concerned about generating a minimum return, yet when they were then confronted with the fact that their choice was inconsistent from an expected return perspective, they did not argue with this assertion. Instead, they overwhelmingly changed their choices in the lottery to make them consistent with the expected return point of view. And when I say overwhelmingly, I mean overwhelmingly. 79% of participants that were confronted with the inconsistency changed the options they chose in the lottery to make them consistent from an expected return perspective. Only 13% let their lottery choices stand as they were. Oh, and 8% of the participants were unable to think logically and made changes to their lottery choices in such a way that they were still inconsistent afterward…
What this experiment shows is that our need to be consistent in our actions is so important to us that it overrides other needs such as the need to earn a minimum return. And that is a problem because it often pushes us into a corner where our views are consistent, but partly or completely removed from the reality of markets. In real-life investment decisions, these inconsistencies are often not that obvious. Instead, we make some choices today and other choices tomorrow. But the choices we make tomorrow are influenced by the choices we make today. By trying to be consistent with previous choices, we may invest differently tomorrow than had we not made the choices we made today. And thus, we move inadvertently into a corner where all our investments are consistent, but if the market doesn’t live up to this consistency, we are caught wrong-footed and suffer large losses.