LONDON, 17 March 2003 — Just imagine flipping a coin five times and getting “heads” five times a row.
What are the chances of getting “heads” again the next time? The correct answer is 50 percent. However, there is a strong conviction that if you flip a coin a few times one after the other, the number of “heads” and “tails” will be about the same. In other words, if “heads” comes up five times in a row, you will tend to expect the sixth time to be “tails”. But this is not correct, nor is the expectation that above-average returns are more likely to follow a prolonged period of below-average returns.
This conviction is due to a misinterpretation of the law of averages, also known as the law of large numbers. People tend to believe this law applies to small sample surveys as well as to large ones.
If we apply these findings to the financial markets and look back on the recent (painful) past, we can see that the stock markets have been performing below average for a long time, or in other words, we have had ”heads” several times in a row. Clearly, the press has not overlooked this gloomy reality, but the frequent conclusion that there will therefore be “tails” next time, i.e. that a trend reversal with above-average returns is now more likely, is rather simplistic.
This does not mean that we have to rule out this happy event. However, when making investment decisions, you need to be aware of the fact that this possibility is not, in fact, the most probable.
Interestingly, various studies in the area of behavioral finance show that particularly strategists dealing with investment policy tend to fall prey to the temptation of relying on the law of large numbers and forecast trend reversals too soon.
The reason why many strategists tend to be overly pessimistic after there have been three bull years in a row and overly optimistic after three bear years in a row could have to do with the fact that, together with the law of large numbers, the process of mean reversion is also present at the back of minds. Basically, the idea is that future yields will go back to being close to their historic long-term averages. We too, were of this mistaken opinion last year, but we have acted accordingly since then and are aware of the fact that trends and fundamental indicators can sometimes point in a certain direction for longer than expected. Despite this awareness, there have clearly been more years of positive equity returns than negative performance in the past. Therefore we are of the opinion that it is too soon to give up investing in equities altogether.
The upward path has turned out to be rockier than expected. Investors have been surprised by sudden cold showers and have stood shivering in the icy financial markets. The tricky question of accounting practices was barely out of the way when the bad news about irregularities and accounting errors at Ahold and Qwest arrived. The markets reacted mercilessly again.
Not too much of a good thing, the recent macroeconomic data do not make things look any brighter. US consumer confidence fell to a nine-year low, the worrying balance of trade deficit continued to grow and the recent survey data from the manufacturing industry (Philadelphia Fed) were way below expectations and indicate a further slowdown. In Europe the situation does not look very rosy either: a ray of hope was provided by the recent data of the German IFO Index, which measures the confidence of industrial activity. In addition, there is not much good news coming from the job market. The unsettled economic situation and shrinking revenues have caused a number of companies in Europe to cut costs and announce additional redundancies. In Switzerland alone, three important companies announce staff reduction plans on just one day. Furthermore, the global economy is paralyzed by the latest hot topic: Saddam Hussein and the uncertain geopolitical situation. However, the assessment of the current situation clearly has an impact on our investment policy. For the above-mentioned reasons we believe it is currently not the right time to make big bets with regard to investment policy. We are therefore keeping our neutral allocation of stocks compared to bonds. The one small shift from cash to alternative investments has to do with our stronger orientation toward this asset class due to the purchase of an additional product. In terms of equities our sector strategy slightly underperformed the benchmark. Our overweight in the health care sector did not pay off this month. However, we are maintaining our stance since the growth forecasts for this sector are promising. We are no longer underweight in the telecom sector since we believe the bad news has already been discounted.
On the other hand, we are skeptical about the trends in the consumer discretionary sector and therefore have an underweight position. Regarding bonds, we believe the current recession-low interest rates will not continue much longer and are therefore keeping maturities short. In the area of loans, on the other hand, we regard corporate bonds as very attractive. Reducing debts and restoring balance sheets to regain investor confidence is a top priority and corporate bonds will benefit the most.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
