The hardest thing about being an investor is deciding what to focus on.
One of the most profound problems encountered by investors is deciding what matters. We are faced with an incessant barrage of noise and must somehow parse relevant information from it; it’s like attempting to quench our thirst from a fire hydrant.
The oscillations of financial markets make us obsess over what matters right now: Why did the stock market lose 1.2% today? What is the Fed going to do at its next meeting? What are the major themes that will define markets over the next three years? This carousel of explanation and prediction is the lifeblood of the investment industry. It writes stories, it sells, it creates jobs, it shifts allocations. It constantly tells us what we need to get right in order to meet our goals.
As soon as you step into this world it is easy to be captured by this vortex – if we don’t care about the same things that everyone else does, then we are an outlier. Everyone is talking about (insert topic of the day) so we must be interested and have an opinion. If we want to be part of the game, maybe we just have to play it.
Or maybe not.
Focusing on the wrong things is not only exhausting, but it encourages the worst of our investing behaviours – what we think is an effort to add value is very likely to be destroying it. Instead of engaging in the search for the next critical fragment of information or attempting to predict, with high confidence, the next meaningful variable, we should take a different approach and ask – what really matters?
For it to matter to us, there are two questions we should always ask ourselves about a variable or piece of information we are considering:
– How influential is it likely to be in meeting my objective?
– How knowable or predictable is it?
For information to matter to enough for us to take an explicit view on it, we need two things to hold – we must be confident that it will impact the outcome we are seeking (usually returns) and be comfortable that either the information is already available, or we can accurately forecast it.
Let’s take some examples. Imagine we believe that the level of real yields will be influential for equity returns over the next three years; it is not sufficient to consider it an important variable, we need to believe that we can predict it with a reasonable level of confidence. If we assume that we cannot do this, then the level of real yields is not something that matters enough for us to take a high conviction view on – aside from being appropriately diversified across a range of potential outcomes.
Now assume we are a long-term (10 years +) investor and believe that valuation will be a key determinant of returns over our time horizon. In this scenario, both questions can be answered in the affirmative. The price we pay for an asset is more influential for the long-term returns we receive than anything else, and we know it with reasonable confidence in advance.
There is a caveat, however. If, in the valuation example, we contracted our time horizon – let’s say to one year – valuations would fail the test; although they are knowable, they are just not that influential over the short-run. Being clear about precisely what we are trying to achieve is critical in defining what should matter to our decision making.
The reason that short-term market predictions are so difficult to make is that we do not know what the most influential variables are likely to be (what market participants will care about tomorrow), nor – by definition – can we predict them. For short-term market forecasts everything and nothing matters.
For most investors there are two types of variables, dull and predictable ones (valuation, time horizons etc…) which always tend to matter over the long-run, and exciting and volatile ones, which tend to receive all the attention. This is understandable. Unpredictable variables are changeable, exciting and dominate our thinking. They allow us to weave compelling narratives and express distinctive views. It is hard to forge a career focusing on what everyone already knows and ignoring what everyone is talking about.
A huge host of things influence the short-term price movements in markets and this creates profound behavioural challenges; inevitably leading to erratic decision making and a loss of attention on what is important. A key first principle for all investors should be to define at the outset what factors matter most for us given our objectives. If we focus on these, it might just give us a fighting chance of cancelling out the noise.
credit goes to; behaviouralinvestment