Market crash: The illusion of knowledge

4th October 2011

While reading investment commentary can prove endlessly fascinating, and reporting on it a daily ritual for the financial media, what does this add to our decision-making skills in this climate? Comparing challenging ideas from some of the best minds in the City is, of course, interesting – but information overload can sometimes leave readers more confused.

The noise is hard to avoid, as we reported on Mindful Money last month – it's everywhere across the increasing numbers of media outlets, turning us into news junkies. After all, a "smash-bash-crash" headline grabs readers.

There is the added impact of social media, as we are bombarded with swift responses to market movements on the twittersphere. Just one comment spotted today from a financial adviser follower today: "FTSE100 head towards 4800 again, we're close to end of the beginning. That's the optimistic case. You don't want to know pessimistic case!"

There are the gloomy analysts, consistently pessimistic about the outlook for the equity market, while some remain hopeful that there is light at the end of the tunnel if we hold our nerve.

Yet of course, much of the commentary comes from people with a vested interest in promulgating a particular view, adds the Financial Times (paywall).

Then there are those presenting a particularly stark picture of the economic world, as independent trader Alessio Rastani did in a BBC interview last week. Or there is the view, just as apocalyptic, from investment manager David Kauders in his new book The Greatest Crash (Sparking Books) .

The Financial Times (paywall) says: "Mr Kauders has been warning about high debt levels for years, and any time I have rung him to see if he thought equities were cheap enough to make them worth buying he has laughed hollowly and said he would not be looking to go back into equities until they were yielding more than 10 per cent with a price/earnings ratio under 5. In his book he maintains the bear market that began in April 2000 in the west is nowhere near over."

He maintains the only viable investment strategy remains to own government bonds.

Whether he is right or not, nobody knows.

As an investor, what are you supposed to do with such apparently conflicting guidance? The only option is to make up your own mind. After all, there would be no market if there were no opposing views, because whenever someone buys a share they do so from someone else who at that moment is happy to sell it.

It would be a dull world if everyone agreed with each other

The second lesson to take away from these conflicting views is more important one, and is one psychologists and those commenting on business behaviour are keen to point out. Nobody knows. 

It is the ‘illusion of knowledge'.

Gulnur Muradoglu, professor of finance at Cass Business School, and director of the Behavioural Finance Working Group, says: "It's difficult to process and make sense of all the information out there – there is a lot of work about how people do this. The other aspect is how people should make sense of this. Very narrow financial models can be unrealistic.

"In most cases we know from other areas of life that people will ask those they trust. Normal people use very few leads in making decisions – so it's possible they may jump on one event like Greece and act just on this.

"Just like when we have a disease – how do you process it and make sense out of it? And to make it better you have to be trained anyway. It is difficult for people to understand the details so they are going through the same process of absorbing information and trying to make sense of it. But these are hard economic times, and nobody knows the answers."

Mindful Money's psychologist blogger Kim Stephenson adds: "We think we understand why the past happened as it did, when all we actually know is what happened.

"But we all think we know, and me writing this won't alter the conviction that most people have that they know exactly why events in a chaotic, non-linear, complex system like a market happened.

"So you'll get some lovely explanations and opinions. And they will contradict one another, and maybe everybody will decide one is the right one, or maybe (as usually happens) there will be two or three favorite theories out of the hundreds suggested that most people believe. But at the end of the day, nobody on the planet knows why.

"Nobody knows what is going on, nobody knows what information is important or to what we should assign most significance.  Lots of them think they do and will make lots of noise about it, but they don't know."

The truth is that the future is by definition unknowable.

So in light of the fact that ‘nobody knows', which understandably will be frustrating for many – how can investors make decisions? Well, what about intuition? Every day we don't question it, but in an investment context, it is often deemed irrational. But the hard facts, at present, are proving contradictory.

Intuition as an indispensible tool in investment decisions

In an article ‘How to Think With Your Gut' in Business 2.0, Thomas A. Stewart says: "What the science suggests is that intuition — or instinct, or hunch, or "learning without awareness," or whatever you want to call it — is a real form of knowledge.

"…The practical implications of all this are profound. People who make decisions for a living are coming to realize that in complex or chaotic situations — a battlefield, a trading floor, or today's brutally competitive business environment — intuition usually beats rational analysis."

Brian Block adds on Investopedia: "Intuition can also be useful with respect to timing, which tends to depend not only on measurable factors, but on a variety of issues that are difficult to quantify. We all know that one cannot time the market accurately, but a general idea of how high or low it is can come just as much from intuition as various ratios and indicators."

And, reports Bill Breen in Fast Company magazine, Cognitive psychologist Gary Klein, after extensive research, also promotes the theory of intuition as the basis of quick-fire, ‘right', decision-making.

Comments on George Soros' ability to trade markets, Stocks, Futures and Options magazine says: "According to Soros, his theory informs his decisions, and his body gives him the signals. The making of a self-reinforcing trend brings water to his mouth.
The need for a portfolio shift makes his back hurt. His body "knows" he needs to take action, or to take careful note of a situation before his intellect can grasp it."

Finally, Block says: "…In summary, rationality and facts are vital to the investment process and always will be. Nonetheless, the equally fundamental guiding role of intuition should not be underestimated. Intuition provides orientation in uncertain and unknown areas, especially where there is a high level of complexity. And this is precisely what investments tend to be all about."

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