In today’s Money Morning…the flaw in market expectations…two cognitive biases that could undermine your investments…what a real black swan event looks like…and more…
If you’re feeling nervous or worried these days, I don’t blame you.
Especially as an investor.
There seems to be ‘black swan’ events everywhere you look. Big unexpected events that could derail the global economy at any time.
Take a look at the headlines from Bloomberg yesterday.
‘These are the companies war in Korea would hit hardest’
‘Zombie companies kept alive by China’s $100 billion of debt swap’
‘Terror in Spain shows ISIS is down, not out’
Nuclear war, Chinese economic collapse, terror…
Every day we seem to have a discussion that revolves around one of these three topics. And of course, all in the shadow of the strangest presidency in US history.
But that’s not really what a ‘black swan’ event is.
A potentially catastrophic event is not necessarily unexpected. And conversely, a ‘black swan’ event is not necessarily bad. Though most situations in finance that attract this description are.
Today I want to discuss a bit about what true black swan events are. And why they affect the markets so much.
It all starts with market expectations…
The chicken and the egg
Stock markets are forward looking creatures. The stream of daily prices reflects expectations of the future. Not the past. Sometimes people forget this.
When a company releases a great set of earnings results only to see its share price fall, investors can get confused.
There may be a few reasons for this, but the most common are that expectations weren’t met; the market expected even better. Or there are signs that the future won’t be as rosy as was hoped; perhaps slowing sales growth.
The daily price of a stock or asset reflects the weight of investor opinion regarding its future prospects. It’s a reflection of every single investor’s view of the future, in a single number.
For that reason, it is thought to be quite accurate. The wisdom of the crowds narrows down the range of possible error.
But the future is of course uncertain.
And this process of price discovery has a secondary effect. An effect that can skew expectations over time.
It’s fact that the daily price influences the expectations of investors, as well.
Think about that for a second. The price is a reflection of total investor expectations. And the price also influences expectations.
This is a weird situation. It’s a feedback loop where expectations determine price and price determines expectations.
It’s like the chicken and egg scenario. What comes first?
I’ll return to this shortly. Because this is at the heart of why true black swan events become possible over time, especially when markets think they know where things are heading.
But first I want to explain why price has an effect on investor’s expectations.
It’s our brain’s fault you see.
We are hard-wired to let certain cognitive biases lead our thinking. Especially when we are dealing with uncertainty and guesswork.
Two Israeli psychology professors have spent the best part of four decades proving how the human mind errs, systematically, when forced to make judgements about uncertain situations.
One of them won a Nobel Prize in economics for this research.
Michael Lewis, author of the bestselling The Big Short, just wrote a book about this called The Undoing Project. I suggest you read it.
It’s a great book, with a lot of useful information wrapped up in an interesting story about the two professors (who famously fell out, some say due to natural human biases).
But for the purposes of this article I want to concentrate on just two biases they uncovered. The ‘recency’ bias and the ‘anchoring’ bias.
The recency bias is the natural inclination to give more weight to recent experience when making a decision. It’s why investors are reluctant to invest after a big crash, despite the opportunities being a lot better than average.
The anchoring bias is the tendency to grab hold of irrelevant and often subliminal information in the face of uncertainty to make decision. If I told you for example that there are 2.8 million people in Uganda. But then I admitted I actually don’t know, and asked you how many you thought there were.
How many would you say?
Try it, then look it up. Chances are that your answer would have been closer if I’d not anchored it with my irrelevant 2.8 million figure.
In the markets the price of a stock or the market level itself also contributes to both of these biases.
This then results in a range of expectations that can differ quite wildly from reality. Crowd wisdom becomes mass delusion.
These two biases probably best explain why market expectations tend to reinforce over time. And when this effect is strong enough, the chances of a true black swan are higher.
A true black swan
Let’s tie this back into what a true black swan is.
Markets reflect a range of opinions. These expectations affect the price. Which in turn effects investor expectations.
Over time the market gets confident that a certain situation is true. Therefore, investors think an outcome too far from the market price, ‘Situation X’, could never happen.
Consider this quote from former Chairman of the US Federal Reserve Alan Greenspan:
‘The housing bubble became clear to me sometime in early 2006 in retrospect. I did not forecast a significant decline because we had never had a significant decline in prices, and it’s only as the process began to emerge that it became clear that we were about to have what essentially was a global decline in home prices.’
This is what a true black swan event is.
It’s unexpected. It had ‘never’ happened before. Or so some think. This is usually a perception issue in finance. Recency biases may cause us to forget, but the same problems rear up in new ways every decade or so.
Usually in some form of debt bubble.
But this is a true black swan event. The property market got hit hard in 2007 because the expectations weren’t factored in. Not at all. The events were simply off the radar.
That turned into the Global Financial Crisis.
Remember that when you read about events like war, terror and debt, and wonder why the markets remain high. You can bet that this is due to the fact that the probabilities have been factored in in some way.
To a degree at least. Maybe the market doesn’t believe it’s as bad as the headlines say? Or maybe they don’t think the outcome will be bad for stocks?
When a true black swan event hits, market expectations are blown out of the water. And you won’t be reading about it before the event.
That’s when the real volatility begins.
Editor, Money Morning
PS: The biggest investor opportunities arise when the market is too overconfident in its ability to forecast the future. My colleague Greg Canavan thinks he has found a sector that the market has got wrong. Very wrong. If he’s right, this sector could be poised for an unexpected bull run over the next 12 months. Find out more here…