Simple minds – just because an idea is easy to understand does not necessarily make it right

7th December 2011 by The Value Perspective

By Kevin Murphy.

One element of psychological baggage most investors bring with them to the stockmarket is a fondness for thinking in terms of ‘simple stories’. Rather than understanding the complex tapestry that is markets, valuations and economics, some prefer to reduce everything to simpler ideas with which they feel more comfortable.

An obvious example of this from the last 12 months or so has been the market’s love of the so-called ‘risk-on’ and ‘risk-off’ trades. Markets going up? Increase risk in portfolios. Markets going down? Cut back the risk. Everyone can understand simple stories such as that and so they stop worrying about the underlying logic and, often, whether they are even right.

Take a simple story that is prevalent in the world of sovereign debt – countries are like dominoes and once, say, Greece topples over, others must necessarily fall too. But what if this is overly simplistic and one country could fall without bringing down any others? What if a better analogy was a forest fire and the European Union, European Central Bank and International Monetary Fund are looking to build a firebreak big enough to stop the fire spreading elsewhere?

Looked at in terms of European GDP, Greece is tiny, accounting for just 2.5%. Few banks – and certainly no major ones – have sufficient exposure to the country to cause a problem in itself. No UK bank has any exposure to Greece that would cause it even to blink in the event of a debt default.

However, investors have become fixated on the question of which country might be the next domino to fall. To their mind, it cannot just be Greece – it has to be Portugal, then Ireland, then Spain, then Italy, then Belgium, then France … and then we are all in real trouble.

For many, the end result of such thinking is they would rather take the certainty of negative real returns from cash ahead of the short-term uncertainty. However, what history would suggest, starting with valuations where they are today and on a three or five-year basis would be very positive real returns – albeit with possible further short-term falls – from equities.

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1 thought on “Simple minds – just because an idea is easy to understand does not necessarily make it right”

  1. Critic Al Rick says:

    Experts – just because it needs specific and complicated jargon to describe it does not make it necessarily right.

    Consider the current economic Mess; partly the outcome of fundamentally flawed academic economic theory. Such economists have developed and complicated theories so much that they have lost the plot. For instance, they see GDP, more particularly Growth, as THE criterion by which to judge the success of an economy.

    It is far simpler to consider an economy as a single business; the success of which is judged by its Profit, i.e. the economy’s Balance of Payments; and not necessarily by its Turnover, i.e. the economy’s GDP. As people with business acumen (commonsense) know, the size of a business’s annual Profit is neither necessarily nor consistently proportional to its annual Turnover. A very poorly run business can have an increasing Turnover whilst having a decreasing Profit.

    And that is what has happened with many economys in the West. UKplc hasn’t made a Profit in nearly 30 years; i.e. the UK has been run very poorly indeed. And that is essentially the combined product of academic ‘excellence’ and commonsense ‘illiteracy’.

    The most ingenious ideas are often the simplest. Put another way; the simplest of ideas sometimes only emanate from the most ingenious of minds.

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