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Why conventional wisdom has been surprised this year: a behavioural assessment

Hopefully you don’t need me to tell you about the perils of forecasting. Nor is this the place to question why we should make forecasts at the end of December as opposed to any other point of the year.

As we near the mid-point of 2014 though, the calendar year has provided a clear example of how we as human beings can be both perpetually overconfident in our ability to forecast, and just as perpetually surprised by our failure to do so effectively. It has also shown how, in our quest for certainty, key assumptions can often be lazily constructed without much actual thought.

The mania of the investment industry for year ahead predictions at Christmas time does serve one useful function: it provides a good opportunity to assess the general mood and opinions of a broad section of the market. And at the end of 2013, the consensus certainly seemed to be bearish on bonds, while equities, particularly in the US, would “inevitably” outperform.

Just as fortuitously, the end of December marks, almost to the day, the point at which bonds stopped selling off and embarked upon one of their best starts to the year in over 20 years (see figure 1).

Figure 1: Changing perceptions of Government Bonds

So what is going on here? This blog post isn’t an exercise in schadenfreude or “told ya’s” – indeed the performance of a couple of months does not invalidate most of the arguments that people have made about the risks to low yielding fixed income assets today. What I hope to do is explore how as human beings we can consistently get these types of predictions so wrong; and not just due to analytical failures but due to the impact of our own emotions.

Emotional biases in our forecasts

Many bearish arguments for bond markets in 2014 were on the surface reasonable, coherent, and compelling. A recovering US economy, “tapering”, and an improving sentiment towards equity all seemed plausible on the surface. Beneath the surface however, the language and arguments of these forecasters often revealed emotional biases, and these biases can serve to make us inappropriately confident about what we think will happen in the future. Below are just some examples of behavioural forces which seemed to lie not very far beneath the surface at the start of the year.

Extrapolation

One clear example seems to be the impact that past performance seemed to have had on seemingly objective viewpoints. What behavioural psychologists call extrapolation often manifests itself in financial markets when people’s views are led by what has just happened to them. You would think “expert” forecasters would be immune to this, but if this truly were the case it seems strange that the consensus view against bonds would emerge after a major sell off in the bond market rather than before.

Representativeness

Many bearish views on government bonds were also couched in a language comparing the current market to past events. Whether or not market moves represented “a return to 1994” was a common way for commentators to describe the latter half of 2013. While this may be emotionally appealing however it can be dangerous. From a statistical standpoint, a “sample of one” is hardly a robust means for thinking about the future.

Behavioural psychologists have shown that investors often overweight the probability of events that they have experienced before, particularly when these memories have an emotional attachment. For bond investors, few experiences have been as painful as 1994 – but the current environment is not 1994 and we should not allow our emotions to cause us to behave as if it is.

Emphasis on a single issue

When we over-simplify the issues of the day we ignore the true propensity for the world to surprise us. As human beings, we crave simplicity and explanations that are easy to think about and hate ambiguity or complexity.

As investors, doing this can leave us highly exposed if these surprises do emerge. “Tapering” was a clear example of this. Investors became obsessed with Fed policy (figure 2 shows the almost exponential rise in news stories referring to the word “tapering”), Committee minutes were dissected and second guessed, and the often unhealthy obsession with short term macroeconomic data such as non-farm payrolls reached fever pitch.

Figure 2: Focus on a single event

Investors and commentators are also often overconfident in reducing forecasts of the future to a few variables in this way. This year the argument that “The US economy will continue to improve, the Fed will start tapering, and that will be bad for bonds” was a common one. However, while the first two points came true, the last did not. Other things can and do happen and we must adjust the confidence we attach to our decisions accordingly.

Most importantly, these types of arguments tended to ignore the starting point of value – it seems intuitively obvious, though it runs against efficient markets theory, that an asset that is cheap can go up even if it receives bad news.

What happens from here?

It remains to be seen what will happen to fixed income assets in the rest of the year, but as we have discussed elsewhere it can be risky to oversimplify arguments about where we think real interest rates may go.

Those who were bearish on bonds in January may still end up being right, but what the first half of the year has shown is that it is extremely dangerous to apply too much confidence when assessing the future. In particular we should be on the look-out for those who now seem to have changed the views purely based on what has happened to prices so far this year.

By simply being aware of the existence of behavioural biases, such as those mentioned above, we can go some way to avoid falling victim to them. Understanding our own motivations, and having a healthy degree of humility about what we can and cannot know is key to making us all better investors.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.