Classical physics is a science governed by universal laws that we can measure with absolute precision and understand rationally. By contrast the investment universe is a tumultuous sea of unpredictability more akin to the realm of quantum physics – where things are not subject to rational behaviour and prediction.
In order to inject a degree of certainty and stability to the field of investing, I have identified five universal rules that have stood the test of time and provided an invaluable guide to my decision making process.
-The first rule states that sentiment is negatively correlated with actual investment returns. An asset where investors are the most pessimistic will go on to outperform in the future and vice versa. The table below best illustrates this phenomenon and presents a powerful case for contrarian investing. The winning sectors of the last decade and those where investors were the most optimistic became the worse performing sectors over the next decade.
Another defining piece of evidence was the cover story of Business Week in 1979 – titled ‘The Death of Equities. The opposite actually occurred – 1979 was the beginning of a multi-decade rally. Elsewhere pundits were pushing the peak oil theory in 2008, today the pendulum has swung the other direction and oil has fallen by more than 50%, an unthinkable feat back then. This correlation is exacerbated by recency bias where we try to predict the future by extrapolating recent trends and projecting them into the future. But this cognitive bias ignores the fact that abnormal price levels indicate that something is unsustainable, meaning it cannot continue forever. Markets adapt and revert back to an equilibrium – a sort of reversion to the mean.
As a challenge to this rule – Can you name me an asset where investors have been almost unanimously bullish that went on to outperform over the next decade? I can’t.
-The second universal rule states that the majority of expert forecasts in economics and investing will be proven incorrect. The historical track record of forecasters is nothing short of abysmal. Philip Tetlock, a professor of psychology collected a database of more than 25,000 expert predictions for his book – expert political judgement, published in 2005. His conclusion is that most experts are frequently wrong and their predictions equivalent to random guesses.
This reason for this is a global economy which is increasingly complex and doesn’t operate in clean and measurable ways like classical physics. While experts treat the investing universe like classical physics, it has a lot more in common with Quantum Physics and ‘Heisenberg’s uncertainty principle’ – were precise measurement is impossible. At the subatomic level the world is fundamentally unpredictable and things will happen that nobody could have seen coming.
Professionals are unable to recognise this because of the incredibly high rewards for making correct predictions. It is the unchanging and universal nature of greed that makes certain the continuation of this rule. Investment professionals ought to spend less time accumulating information to make forecast about the ‘known unknowns’ and instead be content that we know very little.
I want to credit Morgan Housel, Former writer for The Motley Fool for bringing to my attention the very apt physics analogy.
-The third rule demonstrates that the longer a stock is held, the greater the probability of an investor generating a positive return increases. One of my favourite statistics on the stock market is that the probability of making a positive return increasing from 74% over one year to 94% over 10 years. See table below:
The difficultly with this rule is that few investors have the patience to hold shares for more than 10 years. According to data from the NYSE, the average holding period for stocks is now less than one year; a drop from more than eight years in the 1960’s Short term movements in the stock market are driven by emotion and irrational behaviour. The only way to capture these positive returns is to hold shares over a long-term horizon when the market reflects the underlying value of these businesses.
Another key problem of short-term investing is that if you’d missed the 25 best performing days since 1970 (S&P 500), your returns would go down from 1910% to 371%. These days occurred during periods when volatility was above average making it notoriously difficult for a trader to capture these returns. While it would extremely difficult to miss all the best days, it is certainly possible to miss some of them, highlighting the importance of staying invested. To paraphrase Nick Murray – time in the market; not timing the market would provide investors with their greatest natural advantage.
-The fourth general law states that Equities will outperform corporate bonds, government bonds and real estate over the long-term.
The Barclays equity gilt study 2016 is the UK’s foremost source of data on long-term asset returns. The study has been published every year since 1956 and the consistent takeaway is that equities have delivered superior returns over the long-term than bonds or cash. For example over the last 50 years equities have produced a real return of 5.6%, government bonds 2.9% and cash 1.4%. Data for the US comes to the same conclusion; the S&P 500 produces a real return of approximately 8% every year, outperforming bonds and cash.
Why do equities outperform bonds?
The theory states that because equities are inherently riskier and more volatile than bonds, they will offer a higher return (aka risk premium) to compensate investors for holding them. Furthermore by owning a part of a business, you are sharing in the entrepreneurial spirit that is virtually certain to deliver returns in excess of bonds in the years ahead. All told, by buying great companies you are making an optimist investment on the ingenuity of mankind. And what history has taught us is that the ever-present doomsayers have been proven wrong time and time again.
–The fifth rule of investing is a Buffet quote on Isaac Newton’s three laws of motions. Had he not lost a fortune in the ‘South Sea Bubble’, he might have well gone on to discover the fourth law of investing – “that for investors as a whole, returns decrease as motion increases”.
One of the most amusing anecdotes in favour of this law was an internal study by Fidelity to find out which accounts had performed the best. The results were staggering, the best performing accounts were from people who were dead or had forgotten they even had accounts. With access to more information that ever we are under constant pressure to fidget, to adjust asset weightings or buy the next hot investment. This increases the odds of making poorly timed, bad investment decisions and heightens transaction costs. I think the father of value investing Benjamin Graham describes it more eloquently than me when he said “The investor’s chief problem—and even his worst enemy—is likely to be himself”.