26 August 2019

Simply unpredictable

What will happen in the global financial markets tomorrow, next week or over the coming month?

It’s tempting to speculate, isn’t it? Indeed, speculation about the short-term direction of shares, bonds, currencies and commodities represents a good chunk of the output of the financial media every day.

To be fair, people have a natural curiosity about the future, particularly when there is money at risk. This makes it understandable that the media would seek to feed that curiosity in its coverage.

The problem is that financial markets are inherently uncertain, which is why the sixth of our seven investment principles is ‘forecasting is folly’. Prices move randomly in the short term and there is little for investors to gain by trying to second-guess them.

This point is easier to understand if you reflect on the fact that what moves prices is new information. It might be an earnings report involving an individual company, a regulatory ruling affecting an industry, a data release relating to an entire economy or a geopolitical development that affects the whole world.

Prices are always changing as new information becomes available and the biggest changes in prices tend to occur following news that no one expected. For example, opinion polls might suggest a specific political party is certain to win a major election. Markets will price for that eventuality. But if there is an upset, prices will adjust very quickly.

What this means is that successfully speculating on short-term movements in security prices with any consistency requires an ability to accurately forecast the news, not once, but time and time again. We’ve yet to meet such a person.

But it’s even harder than that! Even if you could forecast the outcome of news events — say a G7 statement or an interest rate change or a merger — to benefit from it, you still need to be able to forecast how the market will react.

Now that’s especially tough because what moves prices is the degree to which the news lines up with what’s priced in. You might get a weak employment figure, for instance, but the share market might still rally if the headline figure is not outside the bounds of expectations.

The folly of forecasting markets is also partly because events that dominate media attention do not tend to occur in isolation. A big economic announcement might have been expected all week, but what if it is overshadowed on the day by a development in the Middle East that upends the oil market and drives equity prices lower?

In fairness, we doubt the media will ever give up on constructing speculative ‘stories’ about markets by linking fundamental news about the economy or earnings to price changes. It fills column inches or airtime and there is a real appetite among the public for tidy narratives that link cause and effect.

But for the individual investor, it is best to distinguish between the daily noise of news and security price movements from the long-term signals from capital market returns. The latter are more predictable.

We know that over time, there is a return on investment. If capital markets did not ultimately reward investors, there would be no appeal in investment!

But the returns are not there every day, every week or even every year. Timing them is impossible. What’s more, we don’t need to know which individual asset classes, markets or securities will deliver the strongest returns next.

This is best illustrated by the Periodic Table of Investment Returns, from Callan Associates in California. This shows the annual returns for various asset classes over 20 years, defined by indexes and grouped by colour.

Each column illustrates the returns for each year. Those with the biggest returns are at the top and those with the lowest are at the bottom. It looks like a randomly generated patchwork quilt, doesn’t it? There is no discernable pattern.

Sometimes, emerging markets will top the table. Other years, it will be cash or bonds or real estate. The long-term premiums from these assets are available, but they are not evenly distributed.

This means that to succeed as a long-term investor, you need to take a bigger picture view, focusing first on how you allocate your capital across different asset classes, like stocks, bonds, property and cash, and secondly, on ensuring you are adequately diversified within these asset classes.

By having a little bit of all those asset classes, you are guaranteed to reap the returns when they appear and you don’t have to worry about market timing.

Finally, success over the long term requires discipline and sticking to the plan that is made for you, attending to what you can control (asset allocation, diversification, cost, taxes and rebalancing) and ignoring, as much as you can, the daily noise that preoccupies the media.

By the way, this doesn’t mean you shouldn’t take an interest in the news. We all want to know what’s going on in the world after all. But it’s a caution against using daily news headlines to drive your investment strategy.

Prices, like news, are simply unpredictable.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

Tax and Estate Planning Services are not regulated by the Financial Conduct Authority.

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