The ability to develop investment insights is more important than absorbing large amounts of financial market information, writes DANIEL GRIOLI.
I have written about some of the reasons why forecasting investment returns doesn’t work. Now I will ask: what should be our approach to understanding where we are now?
“Know your enemy”
We face a barrage of investment related information daily: economic reports, news articles, academic research, political developments, advice from consultants, and more.
It’s vital to have an approach that helps us to find out what really matters: to focus on the signal and not the noise. Sun Tzu famously wrote that in war it’s important to “know your enemy”. This principle is also true of investing.
So the first part of focusing on what matters is to understand our enemy. A simple description of asset allocation is that we’re trying to answer the question of what to reasonably expect in the future and therefore how to invest now to meet our goals. Now our enemy, as it were, is clear.
Our enemy is to understand what the present suggests about the future and invest accordingly. But what sort of enemy is the future?
Mysteries and puzzles
US national security expert Gregory Treverton made a distinction between two types of questions, which he called puzzles and mysteries.
A puzzle is solved by acquiring more information. Each new piece of information collected makes the puzzle easier to solve. As Treverton observed, “Even when you can’t find the right answer, you know it exists. Puzzles can be solved; they have answers.”
A mystery can’t be solved by acquiring more information. If it did, it wouldn’t be a mystery. Mysteries don’t have definite answers. As Treverton explains, a mystery “poses a question that has no definitive answer because the answer is contingent; it depends on a future interaction of many factors, known and unknown… A mystery is an attempt to define ambiguities.”
For example, calculating the earnings per share (EPS) of the ASX 200 is a puzzle. First we collect the EPS data for each of the 200 companies in the index. Next we calculate the index weight for each of the 200 companies in the index. Finally we multiply each company’s EPS by its index weight and add all of the results together.
By collecting 400 pieces of information and performing a few calculations we solve the puzzle. Figuring out whether or not the euro will fail is a mystery. The answer depends on so many variables, most of which are uncertain and, perhaps, unknowable.