Making sense of a confusing market

Strange times are afoot in financial markets with contradictory assumptions being priced into various asset classes. Here’s a great summary of the confusion investors must contend with at present…

In the words of Charlie Munger, ‘If you're not a little confused about what's going on, you don't understand it.’

When navigating confusion is the name of the game like this, successful investors aren’t just focused on riding out a challenging period, they’re also looking for opportunities amidst the chaos. The key to turning challenge into opportunity is a positive long-term mind-set combined with a disciplined investment process. Rarely have these pillars of investment success been more relevant.

What’s going on?

The strange and contradictory moves we’re witnessing across various asset classes can be explained with four words: sharply higher interest rates. After a decade of interest rates sitting at 5,000 year lows (according to Bank of America), we’ve witnessed the fastest increase back to historical average interest rates in history.

It’s this fast pace of interest rate rises which is at the heart of current investment challenges. When central bankers change such a fundamental financial input so quickly, they’re shaking the very core of the financial system. And when investors are confused, some react by looking to financial theory and history for guidance, but most watch market movements for a steer as to what’s happening. Whilst this makes sense to an extent, it’s also at the heart of the current challenge.

There’s a behavioural bias called regency bias which drives investors to overemphasize recent experiences and information when estimating what’s coming next. During chaotic periods of realignment like this, confused investors are often making investment decisions based upon confusing and contradictory market signals. It’s a case of the blind leading the blind driven by regency bias in all its glory.

The key point for investors to be aware of at this juncture is that higher rates are here to stay. Rather than this being an abnormal situation as it may feel, it’s a return or a normalising to roughly the long term average.

Markets will adapt

Once you accept that what’s happening right now is an abnormal response to a normalisation process, it’s easier to see how this is likely to play out… over time, markets will adapt to higher interest rates as they always do. As that adaptation process plays out, the contradictions across various asset classes are likely to dissipate.

For example, if inflation remains higher for longer as interest rates and the oil price suggest is likely, at some point gold investors will need to price higher inflation into the gold market (which is bullish for gold). The significant divergence between residential and commercial property prices is also unsustainable when underlying land values are trending in the same direction. And equity markets will eventually adapt to interest rates being higher for longer without acting like the world is ending.

Strategies to help ride out this confusing period

Who knows how long this adaptation process will take, but the beauty of investing for the long term is that you can view confusing periods like this as opportunities rather than challenges.

With opportunity in mind, here are a few strategies which may help navigate these challenging markets…

• Dollar cost averaging– By investing more into your portfolio at regular intervals, you can take a lot of the stress out of investing. Dollar cost averaging is a simple strategy which allows investors to benefit from the long term upward trend in equities without worrying about all the short term uncertainty. Many successful investors have used this strategy to great effect through periods of confusion like this.

• Stop checking your stock prices on a daily basis – Checking share price movements too often is a self-sabotaging addiction which helps transform investing into a form of gambling rather than the long term discipline it is. If you check your portfolio multiple times a day, it could be time to break this habit in the name of transforming yourself into a truly long term investor.

• Control your information sources– It’s generally accepted that listening to mainstream news headlines has a tendency to make people more negative and reactive. This is the opposite of what investors need during challenging periods like this. Of course, this raises the question: what are the best information sources for investors? Well, there’s a world of useful information out there. Quality independent think tanks like the Kobeissi Letter can be helpful, while reading fund manager letters by free-thinking investors like Mr Buffet can also be fruitful. The benefit of information sources like these is that they’re written by fellow long term investors who’ve successfully navigated many periods of market uncertainty. In contrast, news stories are written by journalists with the intent of generating an emotional response in their readers. By avoiding this trap and focusing on the real investment game, you’ll be increasing your chances of long term investment success.

• Read a quality book on investing like The Psychology of Money which delves into the psychology of investment success. By focusing on how other successful investors have generated their wealth, you’ll get better at thinking long term and viewing periods of market volatility as opportunities.

It’s time to be disciplined

These strange times in financial markets won’t last forever. Understanding this could well be the key to translating current market contradictions into opportunities for longer term investors.

Hence, while fear and confusion are making many investors jumpy and overly focused on short term market movements now is the time to be disciplined about your investment process and mind-set. That means utilising strategies which enable you to hold onto your portfolio whilst taking advantage of opportunities as and when they arise.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.