- 2023 was a year of surprises
- How can investors navigate unexpected events in 2024?
2023 was a year of surprises. Some of them were good: major economies dodged recession, inflation began falling rapidly, and markets were buoyed by talk of rate cuts and AI hype. But some were far less positive: the collapse of Silicon Valley Bank triggered banking sector turmoil in March, while the Israeli-Hamas war heightened geopolitical tensions.
Unexpected events are common, but the market movements that follow can be almost as surprising as the event itself. Sometimes, markets overreact in the face of a surprise, with prices swinging dramatically, only to correct themselves by the end of the day.
Research suggests that this seems to be particularly common in response to events such as industrial disasters or even the death of a chief executive. But markets can also underreact, with prices sometimes barely moving in the face of significant economic developments.
Don’t try to time the market
In 2018, Vanguard economists looked at how portfolio returns fared in the face of ‘economic surprises’, which they measured by looking at significant changes in US employment data.
Their research examined whether portfolio managers could benefit from moving away from a diversified portfolio of 60 per cent stocks and 40 per cent bonds whenever they anticipated an economic shock. In this scenario, the hypothetical investor would change their asset allocation to 80 per cent stocks and 20 per cent bonds in expectation of a positive economic surprise, or to 40 per cent stocks and 60 per cent bonds in anticipation of a negative one.
The answer was a resounding no. The hypothetical portfolio manager would need to be correct 75 per cent of the time to beat the 60-40 portfolio, and that was before trading costs were even taken into account. It seems that even for professionals, navigating economic surprises is incredibly tough.
Brain chemistry
Earlier this year, researchers at the University of Basel looked at how baby mice respond to loud noises. It may seem a million miles away from financial markets, but according to scientists, it could shed valuable light on how the human brain learns to deal with surprises, too. Researchers think that as the cerebral cortex of our brains develops, it forms an image of the world that we then compare against any external shocks. Anything that corresponds to this image is classified as ‘normal’, while anything different registers as a ‘surprise’.
At first, making these comparisons is a taxing process. But the things that initially shock us are far less surprising the second or third time they appear: as we mature and gain more experience, we can much more easily categorise new events as important or uninteresting. The scientists noted that “this increased efficiency makes perfect sense: new stimuli may gain our attention, but do not cause an unnecessarily strong reaction that costs us energy”. It could also help to explain why markets sometimes under- and overreact to surprising events.
The market reaction
In 2014, economists Darwin Choi and Sam Hui used data from in-play football betting to look at how markets respond to shocks. Though not a perfect proxy for the financial market, it's still a pretty good one: big sums of real money are traded, there are ‘shocks’ in the form of goals, and you can even put a figure on how ‘surprising’ these shocks are by comparing the strengths of the two teams.
Choi and Hui found that very surprising events are hard for us to ignore. The economists think that because these surprises require more ‘cognitive processing’, they become amplified and are brought to the forefront of our minds. But this can result in too much emphasis being placed on the new information – meaning market overreactions result.
But when an event is only moderately surprising, investors tend to underreact. In these cases, the new information isn’t enough to persuade us to change our existing world view: it gets categorised as ‘uninteresting’ when in reality it deserves more recognition. Big surprises demand our attention; perhaps it's the smaller ones that we need to look out for.
