As Morgan Housel wrote in the earlier read about our inability to accept uncertainty, we exhibit this trait to know for certain even with our investments, as this piece shows:
“Forecasting most things is difficult and we are notoriously bad at it. Predicting the behaviour of a complex adaptive system such as financial markets is particularly challenging. Our default setting should be to avoid it, where at all possible.”
Whilst the future in general is uncertain, this piece asks the questions if the long term is any more or less uncertain than the short term. Intuitively it seems that the short term is less probable of being influenced by unpredictable events than the long run whose elongated time should increase the probability of rare events to occur. Turns out, it doesn’t work that way with investment returns. The article begins with the market being a voting machine in the short run and a weighing machine in the long run:
“In very simple terms if we want to take a view on the prospects for global equities then there are two things that matter: sentiment (how other investors ‘value’ them) and fundamentals (the earnings stream we receive through time). The importance of each element alters dramatically depending on the time horizon applied.
The shorter the time period the more sentiment dominates outcomes. This creates a prediction problem. It is close to impossible to hold confident views about what events will occur and how market participants (in aggregate) will react to them. The amount of noise and randomness is pronounced, and the range of potential outcomes vast.
As the horizon extends, however, the fundamental factors start to matter more. The compound impact of earnings begins to overwhelm the influence of fluctuating sentiment. If we are making a ten year forecast for an asset class, we are thinking about the accumulation of cash flows / earnings over that entire period, not just what they are by the end of it.
The influence of multiple years of earnings should mean that the range of outcomes narrows as our time horizon increases”
The author shows a graph of how the range of returns tends to become narrower (and hence relatively more predictable) with time.
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