The limits of market wisdom

This appears almost everywhere these days to protect retail investors from unscrupulous marketing that promises the earth. The problem with it is that it is just not always true. There is a host of academic literature that has explored and established the fact that investment assets exhibit trend-like behaviour i.e. if they have gone up, they are more likely to continue to go up, and vice versa. In fact, there is an established strategy within the investment management industry called “trend-following” which relies on this exact phenomenon to deliver strong risk adjusted returns. We even own one such fund in our portfolios.

Volatility is a four-letter word in finance – it is often used as a euphemism for falling asset values and is thus seen as something to avoid. However, in its strictest interpretation, volatility simply measures the extent to which prices move, both up and down. If you are a long term investor and you own a portfolio of assets that you are highly confident will deliver good returns in the long run, then more volatility can arguably be a good thing as it means higher ultimate profits (as long as you are prepared for a potentially rocky ride on the journey).

Strictly speaking this is correct, but it remains bad investment advice if you are trying to maximise your long-term returns. Investor psychology tends to lead to a desire to sell out of our winners (to book profits we can boast about) but to continue to hold our losers (to avoid crystalising losses). The problem with this is that on average, the winners keep on winning and the losers keep on losing – for example look at how few companies rise to dominate their field. So, all we are doing is magnifying losses and curtailing our gains – a strong recipe for underperformance. In an ideal world we want to maximise the profits from our good decisions and minimise the losses from our bad decisions, so we should be running our winners and cutting our losers.

These sayings are not always entirely wrong – but they are incomplete. Each contains some truth, yet overlooks the nuance required for good investment decisions. As discussed in previous blogs, markets are shaped as much by expectations and behaviour as by outcomes, making simple rules unreliable guides. In practice, successful investing requires patience, discipline, and a willingness to question easy narratives.

These phrases will no doubt persist – but investing is not a game of slogans. It is about managing risk, weighing probabilities, and thinking independently.