Wednesday, August 15, 2007

Misleading hindsight

In case you've just spent the past few weeks on a desert island (or a very exotic one), you would have missed one of the most panic-driven sell-offs in financial markets in years, if not decades.

One unfortunate aspect of the latest rout is that most experts don't seem to know how much further markets are likely to fall.

This puts not just experts, but people who rely on experts (e.g. investors), in an extremely awkward situation. Without any conviction on which way to trade, markets can at best go sideways or at worst come crashing down.

In reality, we're simpy in the midst of something the world has witnessed ever since the dawn of time: an extremely rare and unexpected event with an uncertain outcome.

While we usually get to hear about why a major event such as this occured after it occured, we now have the rare opportunity to witness how truly limited our understanding of uncertainty in financial markets has remained despite all of the advances in mathematical modelling and trading strategies.

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There's nothing new about a lurch downwards in markets, otherwise known as "corrections". They usually occur as the result of a market being "overbought", which then leads to an inevitable decline (usually around 10%) and a subsequent "bounce".

At the moment, the exact cause of the downturn is not fully understood, so making a prediction about when and how much of a bounce is likely, is more uncertain than usual.

One explanation doing the rounds is that market participants have failed to learn that they fail to learn, otherwise known as a "black swan" event. This describes how after something completely unexpected happens, we come up with an explanation that attempts to explain exactly what happened and why it was predictable after all, thus creating a false sense of certainty about future uncertainty.

This problem is compounded by people attempting to draw analogies with past events to try and guage how much worse it might get. This effectively uses a backward-looking explanation of the past to help predict what might happen in the future!

If you were to suggest, based on your experiences at the time, that the current episode is similar to the events of October 1987, most people who work in the financial industry would have to take you at your word, since they are unlikely to have been working (alive??) at the time!

The more recent the period with which you make the comparison the more people you are likely to convince. In the end, there is a story to satisfy everyone. However, every story will have one thing in common: a misleading reference to the past in an attempt the predict the future.

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We are at one of those rare times when an expert will tell you exactly what they have always known about the future: very little.

At the end of the day all you can know is what you know. While it may not always be possible to know why something is happening, it is possible to guage the ability of the global economy to weather the storms that come along.

At the moment markets are falling while the global economy is resilient. If the environment were less bouyant than at present then the current turbulence in financial markets would have much wider ramifications than they currently do.

In the meantime all we can do is sit tight and hope for the best!

Sunday, August 05, 2007

If...

Traders who work in the financial markets don't have time for poetry.

This is unfortunate, since there's one poem that contains a lot of helpful advice for those who have been in the red these past few weeks.

The English writer, Rudyard Kipling wrote a famous poem in 1910 entitled, If. It opens:

"If you can keep your head when all about you are losing theirs..."

In the financial world this could be taken as meaning:

"A contrarian investor has much to gain". Or more concisely:

"Buy low, sell high".

But there is also a deeper message. It stresses the importance of self-belief and, more importantly, scepticism towards what other people are saying.

If you take any message from this poem, it should be that while sometimes you may be right and sometimes you may be wrong, if you stop believing in yourself, you might as will give up and go home.

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The past two weeks have seen significant losses across equity markets around the world. At the same time there is a belief among many that not only was it coming, but it's only just begun.

If you stop and consider this for a moment you realise that anything anyone says about the financial markets will always have an implicit bias.

Anyone with an opinion about financial markets either has money, their reputation or both at stake. If someone had expected markets to fall then they are likely to say the markets have further to fall. If they hadn't expected markets to fall, they probably won't expect them to fall much further.

Who should you believe?

The first point to make is that until now a lot of people had been expecting a "correction" in the markets "at some point", so the appearance of such a move is proof to many that not only were they right, but they were right when others had not believed them. This "pride" effect takes time to subside and since pride is always expressed loudly, it tends to find its way into the mainstream media faster than Paris Hilton on her way to jail.

Then there are those who didn't expect it to happen and weren't prepared for the consequences. These people are more in shock than anything else and will be pretty much useless for providing advice until things recover completely, which could take days, weeks or months.

Finally, there are the select few who saw it coming a mile away. They knew exactly when a significant selloff would take place and positioned themselves accordingly. Unfortunately, these people rarely express their thoughts in public. Think about it, if you knew when panic would strike markets and everyone would rush for the exits at the same time, would you advertise that fact? Unlikely.

In reality, the only person whose judgement we can truly rely upon is our own. Today's winner is likely to be tomorrow's loser.

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"If you can make one heap of all your winnings and risk it on one turn of pitch-and-toss, and lose, and start again at your beginnings and never breathe a word about your loss..."

Never breathe a word about your loss. In other words: a loser never says when they losing while a winner usually tells you when when they're winning!

Everyone is wrong some of the time, so when they're right and they let you know this, be wary of not only what they are telling you, but why as well.