It's hard to keep a clear head amid all the noise

It's hard to keep a clear head amid all the noise
By Philip Coggan
Published: April 15 2006 03:00 | Last updated: April 15 2006 03:00. Copyright by The Financial Times

Listening to the news in a foreign language can be a deeply frustrating business. One can pick up the odd proper name such as George Bush or Tony Blair but the words come too thick and fast to grasp the context.

It is rather like trying to follow the financial markets. We can understand, or think we understand, some of what is going on. But we are swamped by the sheer volume of information. Never mind the many thousands of quoted securities, there are bonds, commodities, derivatives and currencies that all seem to hold a message.

But what are they telling us? We journalists can be

at fault here. When the market falls 5 per cent in

a day, we seek explanations. We cannot talk to the actual sellers, for we do not know who they are. So we talk

to the analysts and strategists who follow the market and they tend to

peg the movements to some news item, such as an economic statistic or political development.

On some occasions, this rationale is correct. But sometimes we must fall foul of what the Romans called the post hoc ergo propter hoc fallacy; that because event B followed event A, event A caused event B.

This need for causes may be inbuilt. In his book, Six Impossible Things Before Breakfast: The Evolutionary Origins of Belief, Professor Lewis Wolpert postulates that it is mankind's use of tools that may have led to its belief structures.

The use of tools requires some understanding of cause and effect, especially when we seek to modify those tools (as other animals appear unable to do). But once cause and effect is grasped, a whole set of unsettling questions spring to mind. Why do bad things happen? Why do we die?

Grappling with those questions leads to the development of religions. And one can think of religions as a set of "rules" through which people perceive the world.

Furthermore, the existence of so many religions shows that it is quite possible for different people to have extraordinarily fervent, and contradictory views, on standards of behaviour. Some of them must be wrong.

When investors approach the financial markets, they find they need to make decisions in the face of overwhelming uncertainty. These decisions, if not quite life and death matters, have enormous importance for their wellbeing.

So they tend to take short cuts. Some try to opt out altogether, sticking with cash on the grounds that all other assets are too complex or too risky. Others go to the other extreme, risking all in an attempt to get rich quick; six years ago, such people were day-trading dotcom shares, two years ago, they were gearing up to buy property; now, perhaps, they are getting interested in commodities.

In most cases, such investors will not have examined all the facts but will have (consciously or unconsciously) selected those that best suit their case. There will usually be a "story" that they have adopted, whether it be the transforming nature or new technology or the shortage of housing in their region.

Investors will tend to ignore evidence that contradicts their story and regard those who take the opposite view as fools or knaves.

But the key is always that the price of the chosen asset is going up. That movement gives investors the essential confidence to believe in the story and indeed attracts others who fear they are missing the bus. The price movement "proves" they are right and the sceptics wrong.

A smaller subset of investors may take a completely contrary tack. They may fall in love with an asset class (usually gold) and predict vast gains, somewhere in the future. If the price moves against them this is not evidence that they are wrong but proof of some dark conspiracy, usually involving central banks.

A third set falls in love with a technique, rather than an asset class. This often involves charts, or long historical patterns. They tend to resort to "proof by anecdote"; so-and-so uses charts, he is a millionaire, therefore charts work.

All the groups I have described tend to believe there are, at heart, simple rules that guide the markets.

Alas, things are much more complicated. It is almost 20 years since Black Monday, when the US stock market fell 22 per cent in one session. But even now, there is no universally agreed rationale for the market's sudden plunge.

The more one studies investment, the more complex it seems and the folly of attempting to predict market movements over the next month or six becomes increasingly clear.

The truly smart investor should know his limitations. A portfolio should be planned for the long term, not the next year. It must allow for the possibility of being wrong; the entire portfolio should not be bet on one asset class.

Portfolio changes should be limited and based on one of two things. The first is genuinely "new" news, in the sense of war or revolution; everything else can be dismissed as background noise, like the news in a foreign language.

The second is reversion to the mean. One should take advantage of the addiction of others to simple solutions; reducing holdings when they drive valuations to euphoric levels, buying when those asset classes are being sold on the cheap.

These simple rules will not make investors rich quickly. And nor do they offer any easy answers at the moment. As Alan Greenspan has remarked, the prices of risky assets have generally been forced higher; it is hard, taking the long view, to see anything as a wonderful opportunity.

philip.coggan@ft.com