On rational optimism

Harold Pinter’s The Birthday Party is perhaps his most celebrated play. In a shabby seaside boarding-house, Stanley Webber, a retired pianist, is visited by two disquieting strangers, Goldberg and McCann. The Birthday Party introduced a generation of theatre-goers to the Pinteresque pause, to Pinteresque word play, to the ‘comedy of menace’ and ‘the theatre of the absurd’. There is an anecdote about the play that Pinter himself frequently retold. Having seen a recent production, a woman wrote to the playwright and asked,

Dear Sir, I would be obliged if you would kindly explain to me the meaning of your play The Birthday Party. These are the points which I do not understand: 1. Who are the two men ? 2. Where did Stanley come from ? 3. Were they all supposed to be normal ? You will appreciate that without the answers to my questions I cannot fully understand your play.

Pinter’s response:

Dear Madam, I would be obliged if you would kindly explain to me the meaning of your letter. These are the points which I do not understand. 1. Who are you ? 2. Where do you come from ? 3. Are you supposed to be normal ? You will appreciate that without the answers to my questions I cannot fully understand your letter.

Touché.

In his best-selling book Sapiens, Yuval Noah Harari asks what it is about the human species Homo Sapiens that caused it to win out against all its competitor species during man’s prehistory. One of his answers (spoiler alert) is that the ability of Homo Sapiens to cooperate in large numbers arose from our unique ability to believe in things that exist solely in the imagination, such as gods, countries, and money. Human beings, he argues, have a distinctive cognitive capacity for fiction.

Our aptitude for the largely imaginary also leaves us with a perverse requirement for certainty where certainty cannot exist. (Nobody, other than economists, ever said that human beings were either consistent, or rational.) A good example is financial market commentary provided by traditional media. Why did the market perform the way it did yesterday ? Traditional media will tell us. Whether there is any fundamental ‘reality’ or substance to their account is debatable.

The following is an extract from our book Investing through the Looking Glass (Harriman House, 2016):

If you consume mainstream financial media in the hope of attaining enlightenment, you are dining in vain. Thomas Schuster of the Institute for Communication and Media Studies at Leipzig University has offered an excellent overview of the role of the media in shaping price discovery and fostering irrationality. One of the more dismal and now thoroughly discredited beliefs associated with the Efficient Market Hypothesis states that at any given time, securities prices reflect all available information.

By way of example, Schuster cites the stock of a company called Entremed: “Within a year, if all goes well, the first cancer patient will be injected with two new drugs that can eradicate any type of cancer, with no obvious side effects and no drug resistance – in mice.” New drugs are said to lead to the complete eradication of tumours. The New York Times reports the story on the front page of its Sunday issue. The company holding the licence for the active substances is named: Entremed. Its stock price immediately surges by 600%. As Schuster points out:

“The news is spectacular and exciting. But it is not new. The New York Times itself had reported about the new therapy of tumours in animals in an article half a year earlier. Financial economists are amazed by the stock price reaction to the non-event as well. According to the efficient market hypothesis, which says that all available information is always completely reflected in prices, the republication of the story should not have provoked any significant price reactions. But what happens in this case is exactly the opposite. The Entremed stock reacts twice: to the publication of the original news. And, much more violently, to the prominently placed re-run of the research report on the Times cover. (Other biotechnology stocks rally sharply too.) The stocks of a whole branch of industry rise, as it seems, because some newspaper journalists have repackaged already known research results a second time.”

These days, nailing the efficient markets theory is admittedly like shooting dead, bloated fish in a tiny barrel. But it is, of course, absurd to believe that all market participants are equally well informed. One might just as well say that all market participants are equally intelligent. The reality has to be that some investors are more equal than others, and some are certainly better at rapidly interpreting supposedly new, or genuinely new, information. Some investors also have to be better at knowing or surmising when not to act upon new information that might simply be noise. It would have been wholly legitimate trading behaviour to participate in the rally in Entremed stock even if one knew full well that the second article represented old news: if somebody is offering the potential to scoop up free dollar bills effectively provided by less informed (or other trend-following) investors, it seems churlish not to participate in the largesse. Exploiting the momentum of irrationally overpriced stocks is not a crime.

Schuster’s criticism of mainstream financial reportage doesn’t pull many punches:

“The media select, they interpret, they emotionalize and they create facts. The media not only reduce reality by lowering information density. They focus reality by accumulating information where ‘actually’ none exists. A typical stock market report looks like this: Stock X increased because… Index Y crashed due to… Prices Z continue to rise after… Most of these explanations are post-hoc rationalizations. An artificial logic is created, based on a simplistic understanding of the markets, which implies that there are simple explanations for most price movements; that price movements follow rules which then lead to systematic patterns; and of course that the news disseminated by the media decisively contribute to the emergence of price movements.”

In volatile markets, where both information flow and the inventory of investor intelligence amassed between market participants are wildly asymmetrical, investors should avoid giving undue attention to the media’s wholly subjective (and possibly conflicted) interpretation.

The irony is that most investors might be better served by cutting out the market commentary altogether. The psychologist Paul Andreassen showed that people who receive frequent news updates on their investments earn lower returns than those who get none.

A recent tweet by Ian Cassel (@iancassel) described the modern investor’s dilemma nicely:

Thirty years ago the best investors had the biggest funnels of information. Today the best investors have the best filters of information.

Thirty years ago, in a pre-Internet era, ‘real’ information was comparatively rare, and therefore expensive. Today, information (opinion ?) is ubiquitous, and therefore largely a distraction. What matters is sifting the truly significant from what is eye-catching but irrelevant.

Which leads us to the newsflow of today, which – from some perspectives – would seem to suggest that an uneasy status quo in geo-politics might be deteriorating towards political and economic chaos. Time was when the prospect of a trade war seemed bad enough. Now, with relations between Russia and the West seemingly plumbing new depths, something limited to just a trade war would seem to be a bonus. And yet despite it all, most of mankind remains on that elevator, bringing ever-improving living standards and unprecedented prosperity.

Our conclusion, from an investment context ? Our primary focus remains on capital preservation in real terms, rather than chasing unsustainable markets higher. Genuine asset diversification still makes sense. Bonds, by and large, do not. Portfolio insurance – uncorrelated assets, exposure to the monetary metals – still makes sense. And from an equity perspective, a focus on compelling bottom-up valuations – almost irrespective of the geo-political climate – makes as much sense as it ever did. Political stormclouds will not shake us out of long term winning propositions. In a speech at the Lord Mayor’s banquet in London in November 1954, Winston Churchill made the following statement:

For myself, I am an optimist – it does not seem to be much use being anything else.