Tuesday, November 15, 2016

What are the best investment warnings?

How is it possible to expect that Mankind will take advice, when they will not so much as take a warning?
-       Jonathan Swift

So what is a warning? A warning is defined as a statement or event that may indicate a danger, problem, or an unpleasant event. With hindsight, we can always find warning signs, but the real question is whether you can see warnings before the fact. The warning has to strong enough to change current thinking. For investments, a warning could be information that contradicts a given narrative. The narrative is the story that generates a specific trade or allocation.

There will always be any number of warnings because all information does not reinforce a narrative. A warning will contradict the narrative for an investment decision. For any portfolio managers, the question is determining how many warnings or how intense does a warning have to be to change an investment position? 

At a high level of abstraction, warnings can come in three forms:
1. Price information
2. Fundamental data 
3. Alternative stories 
What these forms all have in common is that a warning should contradict expected forecasts or beliefs. Confirming information is not a warning. Each of these three forms will have a different level of influence or creditability.

Alternative stories can be a warning because they better fit the facts. A better story should cause worry that your narrative may not be an effective explanation. Managers listen to researchers not just to get other views but as a check against their own opinions. When stories conflict, there is a warning sign. New fundamental information can be a warning because it again conflicts with the current narrative. For example, increasing inflation can be a warning that a bond rally is over. Since expected inflation in directed included in nominal yields, this would be a strong warning. Change represents a warning that the status quo story is not working.

The best warning may be a price signal. It is the best because it is the most painful warning. If your narrative or model tells you prices should be going higher and in reality they are moving lower, there is a clear warning. This is not advice but a signal. A narrative that does not fit the behavior of prices will result in negative returns. A loss holds our attention. Prices serve not only as warnings, but, more importantly, as a form of market advice. The price advice could be that you are doing well and you have insight on market behavior, but the advice can also mean that you are wrong and you need some pain to reinforce the warning.

Whether listening to the warnings of others, reading of changes in fundamentals, or feeling the effects of price moves, these may all serve as warnings, but clearly prices may serve as the best warning and the best advise.  

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