Understanding the Unknown

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Why do markets go up? Why do markets go down? What impact do changes have on expectations for the future? Will gold move above $2,000 an ounce? Will Greece default on its sovereign debt? Will the Chinese property market bubble burst?

There are so many unknowns in the world today that the arena of investment can seem an absolute puzzle, a Rubik’s Cube of conundrums. How can sense be made of all this?

You could turn to experts, experienced players or knowledgeable people for answers but how do you know who knows the correct answers?

One of the most important things for an individual to learn to just what they do not know. This is just as true for the supposed expert as it is for the uninformed individual. It is easy to become beguiled by your own (or someone else’s) accumulated knowledge, experience and therefore assumed understanding. It is the basis of the knowledge system in a capitalist society that knowledge is power and power is money and money is power. In other words, being seen to have higher levels of knowledge is a way of attracting wealth (whether measured via money, influence or attractiveness) and therefore a powerful incentive exists to assume that mantle of knowledge.

A key area to consider is the difference between facts and best guesses – or ‘guestimates’. It is tempting to give more authority to a person or institution that can provide a substantial body of facts. For example, on financial matters, you could assume an hierarchy whereby The West Australian newspaper holds more authority than a suburban paper but less than, say, the Australian Financial Review. In turn, the AFR will be seen as more mainstream than the Economist magazine and therefore less reliable on the provision of sophisticated information. However, what happens when the Economist makes a comment on political matters – do its economic credentials provide its political comment with more authority? In other words, there is an inferred authority that we can give an individual or institution – that may not be factually justifiable. As an example of how this can work, consider how many actors are surprised when their fans expect them to be as capable as the characters that they play… It seems that we humans are not very good at differentiating between assumed authority and true authority.

The assumption of perfect or even near-perfect knowledge is a very dangerous trait for an investor. The demise of Long Term Capital hedge fund is a classic case of point. The company was renowned for hiring financial genius’ and Nobel Laureates. It had access to proprietary knowledge of the highest level and was able to take advantage of small differentials in pricing across currency, equity, debt and commodity markets. However, the company eventually leveraged itself (and came within a whisker of taking the rest of Wall Street) into oblivion. The assumption of perfect knowledge had clouded the chaos of financial markets and led the operators to assume that the world would only operate within tolerances and fluctuations that matched the assumptions of the very clever black boxes that drove their trading tactics.

A core skill that is well worth the gaining is the ability to distinguish between fact and guestimate. Here’s a very small example that can be found when looking at the world today.

“Following a plunge of over 323 points in the Dow Jones overnight, the Australian sharemarket has plummeted to new lows. The crashing markets result from poor US employment figures released yesterday and continuing concern over the possibility of Greek default and the implications for the Euro”. I made this up from the current figures for the respective markets but i’m sure the wording would be familiar enough. It seems that the news commentators feel a need to identify a specific reason why the relevant markets have moved up or down on a given day – even though only a few of the millions of transactions occuring on a given day would have been a direct result of these issues.

What are the facts in here?

  1. The sum total of transactions across 30 of the largest companies in the United States as reflected in the Dow Jones Index resulted in the pricing of those companies falling by a combined 323 points from the previous days closing prices.
  2. The top 200 companies in Australia as reflected in the S&P/ASX 200 Index showed a net combined fall in price from the previous days close.
  3. Anything else is a guestimate.

We do not know all of the reasons that people bought or sold securities. We do not know why some chose to take the prices available on the day. It could have been a fund manager changing investments after losing a super fund mandate, it could have been a person needing cash to boost the deposit for their next home or a proud grandmother buying shares for her grandchildren to celebrate a family event. It is highly unlikely that most of the people buying and selling would have had the ability of the Greek nation to service its bond debt at the front of their minds.

The point of this post is to suggest that you do not have to understand the unknown to be able to operate and make decisions in the financial world – but you do have to know where the limits of your knowledge, experience and understanding lay, and to ensure that your actions are taken with those limitations clearly in mind.

Ponder this next time you see a bucket of figures like those below…

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