As an investment management firm, we are constantly asked for our market outlooks. What will happen when the Fed starts tapering its stimulus program? Are BRIC nations the new PIIGS? What’s going to happen with the housing market? Frankly, our outlook is likely to disappoint. Why? Because we don’t have one. Science tells us that to attempt an outlook for a complex system, such as a stock market, is ill-advised. So let’s let science tell us why we shouldn’t bother with outlooks.
Our explanation begins with Pierre-Simon LaPlace, a 19th century French mathematician and astronomer. LaPlace lived shortly after Sir Isaac Newton, and, like many people in this time, was greatly influenced by Newton’s theory of the Clockwork Universe. In this universe, the clear relationships between cause and effect led to the notion that we could, with great accuracy, predict the behaviour of the solar system. LaPlace took this idea to the extreme and believed if you had enough inputs, you could predict the future indefinitely.
This “intellect” became known as “LaPlace’s Demon” and was a widely accepted view of how things worked in the 19th century. This is also the world that many in the investment business think we live in today: if we are smart enough, and if we analyze things enough, we can figure out what markets are going to do next. If the Fed cuts rates, stocks go up. Works every time – just like the law of gravity.
Unfortunately, lots of people have tried to approach investing this way, and, for the most part, they have failed because we don’t live in the world described by Isaac Newton or Pierre-Simon LaPlace. Instead, we live in a world of complexity.
A world of complexity
Physicists at the beginning of the 20th century showed that Newton’s Clockwork Universe is a mirage. And, without getting too deep into quantum mechanics, something known as the Heisenberg Uncertainty Principle showed that LaPlace’s Demon is not even theoretically possible, because the world is too uncertain and complex.
We change our minds, act emotionally, and adapt to new situations differently each time. This makes the stock market even more prone to error than a weather forecast.
A well-known example of this is the old adage of how a butterfly flapping its wings in China can cause a tornado in Kansas. It might. Or it might not. The weather system is a complex system with so many variables, interactions and sensitivities to the slightest inputs, it is virtually impossible to say with certainty.
Stock markets are also complex systems. Worse, they are “complex adaptive systems,” meaning that the people within them don’t always act the same way under similar sets of circumstances. That’s because we’re human. We change our minds, act emotionally, and adapt to new situations differently each time. This makes stock market predictions even more prone to error than a weather forecast. Not even LaPlace’s Demon can figure it out. The immensely complex inter-relationships of political, societal, economic and human factors are simply impossible to accurately model.
How to plan a vacation
If making predictions is a questionable investment strategy, what are we supposed to do as investors? The good news is that just because a system is complex doesn’t mean it’s hopelessly unpredictable. We just have to respect the limits of our knowledge. For example, we don’t know if there will be a hurricane in Cancun on February 10th next year. But we can say that 97% of the major hurricanes in the Gulf of Mexico form between June and November. So if you’re planning a Mexican vacation, February is likely okay. This is a generalization, and it may be wrong, but the odds are definitely in your favour.
It is the same with investing. Some things you can predict with a fair degree of accuracy, and some things you cannot. The important skill is to know the difference. It doesn’t mean that we don’t care about the direction of the Canadian dollar, the price of oil, or whether the economy will be strong or weak over the next 12 months. We do. It’s just that we know they can’t be predicted with any certainty, so we don’t spend much time on it. Instead, we focus on what puts the odds in our favour, and the range of probabilities around it.
Be boring, make money
One prediction investors can make with a high degree of certainty is that a portfolio of securities with certain characteristics will generate a return over time that is better than the market, with less risk than the market.
So what are these characteristics? For equities, we believe that a portfolio of wealth-creating companies that have a return on capital greater than their cost of capital, led by strong management teams, and bought at a discount to their intrinsic value, will beat the market over time. For fixed income, we believe that focusing on investment-grade credit will provide investors with the most competitive advantage. This may or may not happen during the next calendar year, but we’re comfortable that it will happen over the long term. But while these are simple strategies, they are definitely not easy to implement. It is hard work and time-consuming – a boring process to be sure.
But that’s where good investment managers come into the picture. Top-down predictions are difficult to make with any precision, so time should be spent on understanding something narrower in scope: an individual security. This approach is time-tested, and about the only prediction you can make safely. It may be boring, but it works.