Blogs | November 17, 2011

The power of the Hitchcock principle

What should we ordinary investors do about the fact that stock markets are being battered by the euro area debt crisis?


The answer lies in the Alfred Hitchcock principle. As the great film director told actress Tippi Hedren: “Don’t just do something. Stand there.”
There is a good case for responding to share market moves by doing nothing.

A complex plot
To see what I mean about doing nothing, let’s look at three reasons why shares fall.
One is when shares become more risky. But higher financial risk means higher expected returns; shares fall in response to higher risk to a level from which they are expected to offer higher returns. For the average investor, the pain of higher risk is offset by the compensation of higher expected returns, giving us no reason to buy or sell.
Secondly, it could be that the prospects for real dividend growth have worsened. This could well be a reason to sell.
Thirdly, the market might have over-reacted to bad news. This could well be a reason to buy.

“Nobody knows anything”
But how can we tell whether the market has fallen because of increased risk, worse growth prospects or because investors have over-reacted?
We can’t.
The first rule of thinking about the future is to remember the wise words of another great film man, William Goldman: “nobody knows anything.”
What we do know, though, is that there are some cognitive biases that might predispose us to wrongly sell shares in bad times and so miss out on any recovery.

Encore performance?
One is that we mistake the past for the future. When the market’s down as it is now, you’ll see lots of gloom from journalists and pundits. But this gloom tells us why prices have fallen. It does not necessarily tell us where they are going. But it is surprisingly easy to mistake the two. The opposite error happens in booms. At the top of the market, you’ll see lots of stories of why things look great. But these stories are explanations of what has happened, not forecasts of what will.

The “wild west”
This error can be compounded by another – our tendency to follow the herd. Sometimes, this can be an intelligent thing to do because there is sometimes wisdom in crowds. But at other times it can cause us to sell at the bottom of the market and buy at the top. And the problem is, we can’t tell when the crowd is right and when it isn’t (except with hindsight, which is useless for investors).

An action thriller
Andrew Lo at the Massachusetts Institute of Technology points out another bias. We have evolved to run away from danger. The early human who fled at the first sign of a predator survived to have descendants. His contemporary who paused to think did not. We are, therefore, selected to have an instinctive flight response. This can tempt us to sell shares when it seems very dangerous to hold them – even if we turn out to be rewarded for taking that danger.

The power of the Hitchcock principle
Obeying the Hitchcock principle and doing nothing is a way to avoid falling into the powerful temptation to sell at low prices.
Instead of trying to time the market – which almost no-one can do – we can instead consider using another rule of thumb – the 5/20 rule. This is that we should assume (as round numbers) that European stock markets on average return five per cent a year over the longish term with 20 per cent volatility. This means there is a one-in-six chance of the market falling 15% (5 minus 20) over a 12 month period, and a one-in-six chance of it rising 25% (5 plus 20). Under the 5/20 rule, it is these odds – and not day to day moves in the market or chatter about them – that determine investments in shares.
This is not to say that we should be inflexible about our financial plans. Instead, the flexibility should lie in our lives and our attitude to wealth. If you’re saving for your retirement, be flexible about when you retire. If you’re saving to buy a house, be flexible about how expensive a one you need. And so on.
Such flexibility gives us the freedom to ride the blows of falling markets.
And in making us less psychologically dependent upon them, it also reduces the likelihood of us panicking when the market does fall.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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