Siren Songs

Evidence-Based Insights: Ignoring the Siren Song of Daily Market Pricing

Siren Songs

In IFA’s last Evidence-Based Insights piece, “You, the Market and the Prices You Pay,” we explored how group intelligence governs relatively efficient markets (as well as jelly bean jars) in an imperfect world. Now, let’s look at how prices are set moving forward. This, too, helps us understand how to play with rather than against the wisdom of the market, as you seek to buy low and sell high.

News, Inglorious News

What causes market prices to change? It begins with the never-ending stream of news informing us of the good, bad and ugly events that are forever taking place. For example, when there are reports that a fungicide is attacking Florida trees, orange juice futures may soar, as the market predicts that there’s going to be less supply than demand.

But what does this mean to you and your investment portfolio? Should you buy, sell or hold tight? It often reminds us of the legendary story of the Ulysses Pact where Ulysses (Greek name Odysseus) tied himself to the mast to avoid hearing the alluring siren songs (much like the financial media and investing). In order to avoid his demise, he made an agreement with his fellow seafaring crew to keep him tied to the mast despite his protests and cries.

Before the news tempts you to jump into or flee from breaking trends, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.

Great Expectations

How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.

First, it’s not the news itself; it’s whether we saw it coming. When a security’s price changes, it’s not whether something good or bad has happened. It’s whether the next piece of good or bad news is better or worse than expected. If it’s reported that the aforementioned orange tree disease is continuing to spread, pricing changes may be minimal; everyone was already expecting doom and gloom. On the other hand, if an ingenious new fungicidal treatment is released, prices may change dramatically in reaction to the unexpected resolution.

Thus, it’s not just news, but unexpected news that alters future pricing. By definition, the unexpected is impossible to predict, as is how dramatically (or not) the market will respond to it. Once again, group intelligence gets in the way of those who might still believe that they can outwit others by consistently forecasting future prices.

The Barn Door Principle

The second reason to consider breaking news irrelevant to your investing is what we’ll call “The Barn Door Principle.” By the time you hear the news, the market already has incorporated it into existing prices, well ahead of your ability to do anything about it. The proverbial horses have already galloped past your open trading door.

This is especially so in today’s micro-second electronic trading world. In his article, “Weather vs. Climate,” Dimensional Fund Advisors’ Jim Parker compares the difference between an investor living in the moment to one with a long-term outlook. The “weather” focused investors (see Exhibit 1 below) are ones who tend to live in the moment and focus on the daily market news, pricing and reactions - often making wrong decisions for the long-term. The “climate” focused investors (See Exhibit 2 below) are ones who focus on the growth of wealth over the long-term and tend to fair better over time.

Emotions of Active vs. Passive Investors

Rather than trying to play an expensive game based on ever-changing information and cut-throat competition over which you have no control, a preferred way to position your life savings is to partner with the right investment advisor.

The Emotions of Active Investors Figure below depicts the roller coaster of emotions active investors experience. In the emotional cycle, they wait until they feel confident their selected investments are on a perceived upward trend; then they place their orders. But once prices have fallen, doubt sets in. When that doubt turns to fear, they often sell the investment, resulting in a loss.

In contrast, the Emotions of Passive Investors Figure below shows the relaxed emotions that indexers enjoy by accepting market randomness and relying on investing science instead of making decisions based on emotions. Passive investors invest regardless of market conditions, because they understand that short-term volatility is unpredictable. They know that succumbing to gut instincts and emotions undermine long-term wealth accumulation. They also know that news about capitalism is positive on average — but involves some stomach-churning volatility.

Your Take-Home

An advisor can guide you through the murky or turbulent waters and ensure they don't jump ship in response to the noise by signing a Ulysses Pact. This pact allows investors to agree up front that they will not act on emotions that can lead to irrational and wealth-destroying decisions. It can serve as a promise to one's future self to follow a passive advisor's counsel to hold on and not buy or sell as a reflexive reaction to the short-term gyrations of the market.

If you aren’t already an IFA client and are interested in receiving more information from one of our experienced Wealth Advisors, call us at 888-643-3133.