Inkblots

One of the differentiating features between smart and not-so-smart investors in my view is their ability to know how much of investing is not only beyond their control, but simply the result of random events. Note that in the previous sentence, I did not differentiate between smart professional investors and not-so-smart retail investors, simply because I know that there are professional investors who don’t realise how much randomness there really is in markets and how little their performance really has to do with their decisions.

I recently wrote about finding the next Amazon and concluded with the statement that the characteristics of a stock at the beginning of a decade explains only about 2% of the variation in returns over the subsequent ten years. So, why bother if you have such a low degree of certainty or insight?

Almost 40 years ago, Robert Shiller showed that there is no way macroeconomic fundamentals can explain the volatility of the stock market, an observation that would put him on a path towards winning a Nobel Prize. But it’s not just macro variables that are unable to explain stock market volatility. One of my favourite investment papers of all time is the investigation into the performance of PE-ratios, dividend yields and other common metrics as tools to forecast future equity returns by Welch and Goyal. It’s a treasure trove of information and a master class in humility for aspiring equity analysts and portfolio managers. Going back decades, they find that the metrics used to determine if a stock should perform well or not typically explain about 0% to 15% of the variation between individual stock returns in sample. If you use them for forecasting, you can typically explain 10% or less of the future variation between stock returns. In other words, even if we know the outcome, 85% to 100% of the performance cannot be explained by fundamental or technical factors. Or, to go back to the example about stock characteristics explaining 2% of the performance over the coming decade: that’s par for the course.

It isn’t a big confidence builder to know that after all the hard work of analysing a stock, 90% of the outcome will still be due to luck. Yet, this is the reality of investing.

You wouldn’t know it, though by listening to the daily market reports and commentaries in newspapers, and on TV and websites. There, every day, some analyst or fund manager is quoted with some nugget of wisdom why the market went up or down yesterday. In the face of overwhelming uncertainty, people reward ‘experts’ who can reduce that uncertainty and provide them with guidance. There is nothing wrong with guidance and expertise, mind you. But all too often, this guidance and expertise become simply the interpretation of random inkblots. 

At best, this kind of overinterpretation of random events is harmless and doesn’t cost you too much money (though it usually does cost you at least some performance). At worst, it can be the pathway to a loss of reality. 

I have always wondered why so many investors (both professional and private) like Zero Hedge. To me, it is the Fox News of investing. It is full of conspiracy theories and overconfident statements by experts who claim they understand the inner workings of the market without providing any proof of the efficacy of their methods (usually because there is none). Yet, this kind of conspiracy-leaning market analysis has made the site one of the most read and most successful anywhere, just like Fox News remains one of the most successful cable news channels. More than a decade ago Justin Fox wrote an article in Time Magazine on Zero Hedge which had a lot of truth in it. He claimed that the uncertainty of markets is fertile ground for theories that claim to explain the inner workings behind the madness and randomness. And the closer you are to the randomness of the market (i.e. if you are a trader who monitors the markets constantly and has to ‘explain’ even the tiniest random movements), the more likely it is you can find solace in the certainty of sites like Zero Hedge. I think the sole purpose of these sites is to turn inkblots into something else than inkblots. It doesn’t matter exactly what as long as it seems to make sense to the reader. 

And I think this also where Justin Fox turned out to be vastly optimistic. Back in 2009, he wrote that “I would guess that the site’s growth will slow as the predicted apocalypse keeps getting pushed into the future.” Nothing could be further from the truth. Markets are always uncertain and driven by randomness. And that means that sites like Zero Hedge will continue to grow, to the detriment of investors and their performance.