26 Oct 2022
Among the many psychological biases that dwell in our brain, two should be of particular interest to investors: our dislike of doubt and our desire for consistency. The cohabitation of these twin biases, once we stop to think about it, explains a lot about a lot.
To begin with, we are programmed with a tendency to quickly remove doubt and reach some decision. It is easy to see how evolutionary drift would create animals that do this: for much of our existence, we humans were prey, and one thing that ensures swift removal from the gene pool is for a prey animal to take a long time deciding what to do.
The second bias, variously known under official names such as commitment bias, endowment effect and confirmation bias, helps our brain conserve energy by making it resistant to change. It is also likely that consistency used to serve two additional evolutionary designs: a) our ancestors lived reasonably straightforward lives, so the formation of habits sped up decision-making, which was mostly good (see previous bias); and b) it facilitated alliances and cooperation, which would have been far harder if everyone were constantly changing their minds. It is therefore no surprise that early-formed habits are so hard to shake, a reality that was captured by philosopher Bertrand Russell when he said that “the chains of habit are too weak to be felt until they’re too heavy to be broken”.
However, given how much more complex modern lives are than those of our hunter-gatherer forebears, it is a little unfortunate that nature has programmed in the human brain an anti-change mode alongside a tendency to rush decisions. Together, they lead us to accumulate mental holdings of fixed conclusions that are not often re-examined, even though there is plenty of good evidence that they should be. Human beings are great at interpreting new information so that their prior conclusions remain intact.
Like all psychological biases, both doubt-avoidance and love-of-consistency are most effectively triggered by some combination of uncertainty and stress, both of which are of course endemic in financial markets, and especially prevalent as we write this. Precisely when clarity of thought matters most, our cocktail of biases unhelpfully defaults our conclusions to our encoded beliefs, all but guaranteeing that, even when brought face-to-face with critical, regime-changing events, we will not identify them as such unless we make a conscious effort to re-examine those beliefs. Still, because financial market participants have a monetary incentive to weigh information accurately, eventually they do arrive at a conclusion that reflects reality. This mechanism ensures the long-term accuracy of market prices despite their short-term randomness, and was behind Ben Graham’s assertion that “in the short-term the market is a voting machine, but in the long-run it is a weighing machine”.
It is our view that we are now faced with one such critical moment and that some belief-questioning might therefore be appropriate. After the Global Financial Crisis of 2008-2009, we had a bull market in bond-like and growth assets, and for over a decade central banks went along with it. They kept interest rates low for fear of derailing what has been dubbed the slowest economic recovery in history, and felt justified in doing so because inflation – at least according to their definition – didn’t budge. Bank bailouts couldn’t do it; ZIRP (zero interest rate policies) couldn’t do it; and years of debt monetisation and money printing couldn’t do it. Investors who bought into this narrative and did not change their minds were repeatedly proven right.
Then, in late 2021, this narrative suffered a body blow. Rates were now rising, economies seemed healthy and inflation was picking up. At first, this inflationary spurt was supposed to be “transitory”; then it turned out maybe it wasn’t; then Russia invaded Ukraine and things got a lot worse. But as investors searched the data for an excuse to go back to the previous familiar narrative, the consensus became that the US Federal Reserve (Fed) was going to quickly drive inflation lower by engineering either a soft or a hard landing. Whichever it would be, inflation would soon come down, interest rates would too, and we would all go back to buying exactly what we had been buying before this short unwelcome inflationary nightmare interfered with our trusted convictions. Flows into funds specialising in unprofitable growth stocks continued unabated, despite sometimes eyewatering market losses, and by June 2022 we were in a full-blown relief rally. Doubt was avoided. Consistency won the day.
But. Inflation is a phenomenon of the mind. Its existence is inherently circular: it feeds on nothing more than the widespread belief that it exists, and central banks themselves acknowledge this by recursively basing their inflation forecasts on inflation expectations. A pandemic and a war have now introduced inflation to most people as a very real thing, and central banks have taken notice: both the Bank of England’s Andrew Bailey and the Fed’s Jerome Powell have recently surprised markets with hawkish comments, each time knocking any attempt by the markets to rally.
If inflation is indeed becoming a factor to contend with, not just for this year or the next but for longer, how should we reassess our decade-old confidence that central banks are fundamentally tame? Jerome Powell seemed to imply in his August speech at Jackson Hole that just as until 2021 the Fed was cautious in raising rates for fear of derailing the economic recovery, it might now be cautious in cutting them for fear of stoking the inflationary fire. He has history on his side: our Multi-Asset team tells us that, historically, whenever inflation went over 5%, it took on average six-and-a-half years to bring it back down to 2%. Might we be looking at a multi-year period of higher rates and inflation somewhere in the mid-single-digits? What if TINA (there is no alternative) as an investment principle were over? What if a government bond were to become a legitimate savings instrument once again? If so, the narrative that has driven markets for the last decade is well and truly obsolete. And yet, our psychological biases all but ensure that our realisation of it will only be priced into the market gradually. This is the type of news that travels slowly.
What will the new narrative be? How long will it last? We really don’t know, but it probably won’t be the same as last decade’s narrative.