What we need to know

All investing is about the nature of knowledge. Every time you buy a share you are in effect claiming to know something the market does not: otherwise, why not just hold a tracker fund?

All of us, however, have very limited knowledge, especially of how to make money. We must therefore focus upon useful information and not irrelevancies. Which is actually great news for private investors, because there is a lot of complicated detail we don’t need to know.

For example, we don’t need to know the minutiae of market structure and how orders to buy and sell are processed. Short-term traders need to know this, because this matters much more than valuations for minute-to-minute and day-to-day price moves. Those of us with longer time horizons, however, don’t need to bother. Nor, for the same reason do we need to know the precise maths of options trading. “The Greeks” are essential for traders, but not for us. And nor do we need to know the plumbing of cryptocurrencies such as how Tether, Binance and blockchains work. For that matter, it’s not obvious that we need to know anything at all about cryptocurrencies. We don’t need to invest in every asset.

A bigger temptation for investors is to seek out expiring information. We can spend hours combing company reports and news websites gathering hundreds of facts only for all of them to be already in the price and therefore useless for investing purposes. It is easy to pay too much attention to noise and not enough to signal.

Which poses the questions: what is it that we need to know as investors? What are the signals?

First, there are – or have been! – some good lead indicators of equity returns such as: the dividend yield; the yield curve; the ratio of prices to the money stock or retail sales; or whether prices are above or below their ten-month average. These indicators tell us nothing about day-to-day or even month-to-month price moves, but they are informative of future long-term returns.

Right now, these signals are mixed. The dividend yield and global money-price ratio warn us of a big chance of the market falling, but the yield curve, All-share-retail sales ratio and ten-month average rules are all sending encouraging signals. This, I think, warns us to be cautious about equities. But this isn’t the point. The point is that we are not entirely in the dark about where the market is heading.

We must be careful here, however. These lead indicators are silent on why the market might move. And it’s dangerous to fill this silence, because as Yale University’s Robert Shiller has shown, stories can mislead us not least by creating an illusion of knowledge. Instead, what we have here is evidence of a point made by the political scientist Jon Elster – that we can sometimes predict without being able to explain.

There’s something else we need to know, and can: the cognitive biases to which most of us are prone. There are of course dozens of these. They include overconfidence; wishful thinking; the tendency to be overly influenced by our formative years or the opinions of others; or the tendency to hold onto losing stocks too long. Precisely which mistakes we are most likely to make differs from person to person. But we should be on guard against such errors. As Charlie Munger has said, we must know the edge of our own competence.

Another thing we need to know the risks to which our investments are prone. Such risks go beyond mere volatility, the probability of a fall. There’s also liquidity risk: some assets such as housing and private equity are hard to sell in bad times. There’s tail risk: some assets have a small chance of a disastrous fall. There’s correlation risk: previously uncorrelated assets sometimes suddenly fall at the same time. And there’s behavioural risk: strategies that have done well in the past might stop out-performing as investors wise up to them and so bid away the mispricing. And so on, and on.

Which leads to another thing we need to know: where there is a trade-off between risk and return and where there isn’t. We know that some risks don’t pay. High beta stocks under-perform lower-beta ones. Small speculative stocks like those listed on Aim under-perform safer ones. And Harvard University’s John Campbell has shown that stocks on the verge of bankruptcy do badly despite their big dangers. Some risks, then, are only rarely worth taking.

Others, though, are. Two facts should be central to any approach to stock-picking – that defensive and momentum stocks do better than they should; these facts are robust to different times, places and definitions.

You can explain these out-performances as a story about risk. There’s a danger that defensive stocks will cease to be defensive, and a danger that momentum stocks under-perform falling markets. Personally, though, I suspect these explanations are only part of the story.

But that’s not the point. The point is that we all have limited cognitive bandwidth and so must direct it towards what matters. It’s easy to be distracted by irrelevant noise. We must resist this, and focus upon what it important, true and useful. There is not very much that fits this bill, but we must hang onto it.