It seems that lately, “skepticism” has gotten a bad rap. In fact, in our current climate of deep political and societal division, taking a skeptical position on certain topics could even get you un-invited from your boss’s next dinner party (maybe not all bad?).
The truth, however, is that there is such a thing as healthy skepticism. Any scientist will tell you that the first stage of a hypothesis, long before any conclusion is reached, starts with skepticism regarding the conclusions currently being relied upon. It is this very skepticism that causes a scientist to ask the questions that lead them through the scientific process, eventually arriving at potential conclusions.
The science textbook provided when I was in middle school is vastly different from the one handed to today’s students. Skeptics have questioned, tested, and reassessed the theories we relied upon at the time, challenging accepted data, and bringing new ideas to light.
Skepticism can shed light on biases that we may not even be aware we have. Often, when we arrive at a hypothesis, our minds will automatically search for data that will support that belief. This natural cognitive reaction is known as “confirmation bias”. It impacts how we gather information, as well as how we interpret and recall it. It prevents us from viewing situations objectively, and can lead to poor decision making.
Skepticism may feel like personal distrust to our fellow party goers but, in fact, it’s the right way to go about making thoughtful, rational decisions. Rather than a “non-believer”, challenging social norms, a skeptic is someone who simply wants to dig into their research, and arrive at well-thought out conclusions.
Studying investor sentiment to determine how investors are thinking or behaving, is a form of skepticism. In our investment research, sentiment is continually trending between either “pessimism” or “optimism”.
Why track investor sentiment?
Most people will tell you that the best time to put money to work in the market is when prices are low (an environment marked by pessimism), and that the best time to pull money out is when prices are high (an optimistic environment).
Now, intellectually, we can all decide that we will be contrarian investors. The “buy low, sell high” adage is not a new one. Yet, when you are in the throes of a tough market, or even a really great one, emotion can make it very difficult to stick to your guns.
Want proof?
Just wind the clock back to the last quarter of 2018, when most markets in the world were hitting record lows. If you look at the record of money flows in and out of equity mutual funds and ETFs in that period of time, you will see flows out of funds in the last quarter of 2018 were massive. And, money outflows even extended into January of 2019. Markets had begun rallying, but people were still selling!
In addition, the flow of money back into those same funds turned positive at a much, much slower rate, so evidently, even though the massive pessimism of Q4 2018 has receded, people have not been running back into the market at the same level they ran out. Why? Something I’ll refer to as “Imaginative Extrapolation” may be to blame.
Allow me to explain. It can be easy to believe that what is happening now will continue to happen for much longer than it generally does happen. If the value of your portfolio drops 20% in a period of time, this imaginative extrapolation may take the wheel, conjuring up further, continuous, 20% drops. It’s hard to wrench that steering wheel away when a downward spiral appears inevitable.
For many investors the “feelings” that arrived with the poor market performance of late 2018 have not quite dissipated, despite the quick turnaround, with markets having rallied throughout an incredible first quarter in 2019. Most people know that volatility is part of being invested, but it can make our natural tendencies towards confirmation bias and imaginative extrapolation all the more difficult to deal with.
Are there are ways to improve investment results by being tactical? We think so, even though passive thinking may lean otherwise. Taking an unpopular position can be incredibly difficult. Just remember to remind the boss, as you’re being escorted from the party, that uncommon behavior often leads to uncommon results.
~ Greg Stewart, CIO
