17 June 2022

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The great illusion of investors

Author: Luigi Campopiano

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Europe has become unified and, although still with great differences from an economic point of view, from a financial point of view, it has become easy, thanks to the Eurostoxx 50 index, to invest with a single operation in the 50 most important European stocks. Thus, the possibility of diversification between the indices of the various countries has been eliminated because they tend to rise and fall together during the same situations. Thanks to this type of indices, it will happen more and more that the securities of a mega geopolitical area are bought and sold in bulk. Very slowly, the globalization process will continue and extend: we will have a progressive unification of all the geopolitical areas of the globe, and, little by little, the markets will tend to be more and more interrelated.

The other great dimension for diversification remains, which is time. You can diversify by buying and selling stocks at different times (timing-related choices). Many differences are attributable to the timing of entry and exit from the markets. Unfortunately, most people don't know how to evaluate the correct time intervals to use timing as leverage. Look at the following figure:

The figure shows over 20 years how the S & P500 index went, month by month. These are no small differences. Between September (the most negative) and the month of April (the most positive), the absolute difference between the averages of the two months is almost 4% (it is significant and certainly not due to chance: to the choices of men). A question arises: in the 12 months of the year, investors have different moods (they certainly cannot rationally assume that they can predict with certainty what will happen month by month and how things will change from month to month). Yet, looking at the figure, they act as if they know.

This is because the first great investment illusion is at work here, namely, believing that close-time forecasts are more accurate than those projected into the distant future. This is always true for all other futures in our life, but not in investments because long-term forecasts are more reliable. When will inflation go up? It is not known exactly, but it will go up. Will it be one stable and lasting growth? When will rates go up? It is not known exactly, but they will go up. The illusion of short times is perversely linked to the illusion of forecasts. This depends on the illusion of skill. In the short term, some investors think they are better than others. In short, in the short term, forecasts in the financial fieldwork in the opposite way to that which characterizes all other daily areas, those to which a person is accustomed (for this reason, many short-term differences have been created and accumulated).

Today, various "financial experts" are in vogue on social networks, and many follow their advice and buy the securities they suggest. They are convincing because they accompany their choices with a flood of explanations available to all. The effect is none other than that of the old beauty contest described by Keynes: in the short term, the beauty contest will win not the best background (or the most beautiful face), but what most consider the most beautiful. Unfortunately, beauty, at least that of Keynesian beauty pageants, is very volatile.

The financial choices to be made for our well-being take time, a lot of time. In the short term, let's leave it to the clairvoyants.