Market Bubbles: 4 Lessons For Investors

Vanguard has jumped on the behavioural finance bandwagon with its new model of asset price bubbles. Vanguard has a deserved reputation as a high quality institutional asset manager. Unfortunately its client facing research fails in this case to live up to its brand promise. The model itself is pretty simple and clearly explained. There are four basic elements:

1. investors make initial forecasting errors based on errors in statistical inference;

2. biases to overconfidence lead to excessive extrapolation from recent experience and even rosier forecasts;

3. these skewed positive forecasts are transmitted to larger groups (‘group think’) and influence the wider market;

4. the resetting of these initial forecasts in the wake of data pointing overwhelmingly to the negative lead to excessive caution and an eventual market/ asset price crash.

Vanguard suggest that investors could follow several strategies to avoid moving with the herd. Unfortunately just because they are based upon the latest trend in finance theory doesn’t make them novel, insightful or helpful. Here they are: firstly investors should learn more about statistics and common mistakes particularly in the rush to intuitive judgment; second they need to be ‘more cool and calculating and less emotional’; third they should ¬†focus on the long-term and not be focused on short-term performance; fourth they should use independent external data to sense check their thinking.

The only really useful conclusion drawn from this piece is point four. There are pluses and minuses in relying on independent advisors and consultants as they are subject to the same decision-making biases as their clients. I for one would be much more interested to see more research into the effectiveness of investment decisions made by investment committees. It would also be interesting to consider whether an experienced, opinionated, contrarian non-executive could add value on such a decision-making body.

Find the paper here.

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