The baby is crying, and I don’t know why.
Like all babies, my son Joshua cries because he cannot talk. I check to see if he’s wet, hungry, or sleepy. Then I consider less likely explanations: Maybe he’s too hot or too cold or his clothes are pinching him.
After that, I’m baffled, and it’s easy to entertain crazy ideas: Is there a full moon? Is there a squirrel in his crib? Then I come to my senses and comfort him, hoping that someday I’ll learn what the fuss was about.
Financial news is a lot like a crying baby: First, there is noise and commotion as prices rise and fall. Next, we consider the obvious explanations, followed by the less obvious ones. After that, we’re mystified, so we speculate and hypothesize. The action comes first, and the narrative comes later — if it comes at all.
Narratives Follow Prices
Financial news gives us narratives that are often correct, which is remarkable considering the pressures facing journalists, analysts, and financial researchers. Sometimes the process is comically inept, as I learned early in my career.
In 1985, on my second day of work as a stock analyst, I got a call from the Wall Street Journal. They asked me about the latest move in oil prices, and they quoted me the next day on page two. I was 23 years old and I was already the voice of authority.
Why did a newspaper call a novice analyst? Oil prices were moving, and they needed an explanation. I can’t remember what I said or if it made sense, but I learned a valuable lesson about news, especially financial news: The narrative follows prices because readers want a story.
In my first five years as a stock analyst at Value Line, I learned to explain price movements in a way that made sense to investors. When we made long-term projections, we diligently followed the fundamentals of each company, the industry context, historical data, and the factors driving the overall stock market.
This was a reliable way to approach stock analysis, and I gradually learned the rules of thumb. When a stock had strong price and earnings momentum, we expected it to continue in the short run. But because we were aware of history, we expected things to return to normal in the long run. Momentum for stocks was like momentum in sports: A player might get hot or cold, but they would eventually go back to their old self.
For growth stocks, we followed current trends, as momentum drove prices up and down. For cyclical stocks, we followed the industry cycle in the short run, and we projected supply and demand in the long run. It wasn’t foolproof, but it worked often enough to keep readers interested and to keep us employed.
History told a story and the story made sense, so the past was prologue for our predictions. Among the analysts, we sometimes joked that we worked for “Extrapolation, Incorporated.”
This was a fruitful approach in the 1980s and 1990s, when long-term trends were firmly in place and the global financial crisis (GFC) of 2008 was in the distant future. In those days, a black swan was just a bird, not a freak occurrence that shocked investors and overturned our most cherished assumptions.
My perspective changed when I became a portfolio manager. I ran stock funds in the 1990s at a series of large banks, and I learned that stock prices already reflected expectations and market prices absorbed news faster than I could trade. I also learned that current trends affected current analysis, so reading more research did not help me make better decisions. News is descriptive in nature, not predictive, and this makes all the difference.
Yes, I still had to read consensus estimates to understand investor expectations. And I still had to read the news to help me understand current events. But I was reading more and learning less, and I felt overwhelmed by information.
Tips from Other Portfolio Managers
Fortunately, in 1993 a senior portfolio manager gave me great advice:
“‘Half the research on your desk is a complete waste of time. Figure out which half is garbage and you’ve just doubled your productivity.’
“His point was that most research is backward-looking rather than predictive. Reading obscure financial information may look and feel like productive work, but most of this content has little chance of leading to better results.”
This quote comes from “How to Read Financial News: Tips from Portfolio Managers,” which I wrote in 2016. I interviewed my peers and described how they read the news. In this and the forthcoming articles in this series, I will describe how I apply these lessons as an independent adviser. To put my reading habits in context, I will explain my investment process and my approach to decision making.
Our Process Determines Our Priorities
Setting Our Reading Priorities
Ideally, the value proposition of our firm determines our investment process, and this drives our reading priorities.
Consider the chart above: Are our reading priorities driven by the investment process and our firm’s value proposition? Or does our reading depend on our personal preferences? Are our reading goals feasible, or are they merely ambitious dreams?
My reading habits reflect my role: I own a registered investment adviser (RIA), and I provide holistic financial advice. The firm is fee-based and independent and builds customized portfolios of diversified funds. I am a solo adviser, and I spend most of my time listening to clients and monitoring the market.
I am especially interested in the assumptions that investors are making about the future. Market prices reflect investor expectations and conventional wisdom, so I want to know: Are consensus expectations reasonable? Optimistic? Pessimistic?
No More Stock Picking
I’ve been a stock analyst for most of my career, but today, I build portfolios using funds. My time is limited, and my top priorities are asset allocation and risk management. I want to get the most out of every hour of research, so these days I’m studying China, as the center of economic gravity shifts to the East.
Studying an individual stock, however, just doesn’t have the same impact on client portfolios. There are only so many hours in a day, and it pays to focus on the core of portfolios and not the satellite.
As the chart demonstrates, the investment process determines our reading priorities. We need goals that are feasible, since each of us has limits on our bandwidth. Let me be blunt: I have a baby, a wife on night shifts, and chronic pain from an autoimmune disease. So I don’t pretend to read five newspapers each day before 6:00 a.m.
I can speak candidly because I own the business. Others probably need to be more tactful when discussing work/life balance with colleagues. Nevertheless, an honest self-assessment of our capacity will improve our effectiveness as a reader and investor. And it may reduce our stress.
Simple Rules for Decision Making
My asset allocation process focuses on the US economic cycle, and when the leading indicators start flashing red, I raise cash for clients. It’s not rocket science.
You could say that my investment process is just an algorithm — fair enough. But using an algorithm does not mean going on autopilot. As Paul D. Kaplan observed in Frontiers of Modern Asset Allocation, “Historical statistics should not be blindly fed into an optimizer.”
We always have to ask if the algorithm, which is a model of the world, is working the way it was designed to work. After all, models represent the market, and models are not reality. As Alfred Korzybski said, “The map is not the territory.”
If I were to summarize my rules for decision making, I’d point to Daniel Kahneman’s strategies for decision making. Here is how I apply his rules of thumb:
- Trust algorithms, not people: Use simple rules rather than personal discretion. It is a perennial temptation to tweak the process, but this does not add value.
- Take the broad view: Frame the investment process as broadly as possible. As AQR notes, our inputs include historical experience, financial theory, forward-looking indicators, and current market conditions. We don’t look at these inputs in isolation — we take a broad perspective that includes all of them and try to integrate them into a coherent whole. Unfortunately, the market doesn’t talk, and financial news is like a crying baby, so our narrative isn’t always coherent and it’s never really complete.
- Test for regret: Clients who are prone to regret tend to bail out at the bottom of the market, so assess their risk tolerance for any strategy, and put this in the context of the client’s wealth, income, goals, and personality. Client suitability includes far more than mere regulatory compliance.
- Seek advice from people we trust: Our cognitive biases create blind spots, so I stress test my ideas with colleagues. Constructive disagreement is a key ingredient of the investment process, as I observed in “Nine Guidelines for Better Panel Discussions,” which explains how to cultivate respectful disagreement on a discussion panel and has insightful quotes from nine of my peers. We need to cultivate our own network of trusted confidantes. Find people with integrity and learn to harness the power of their insight and criticism. An investment in these relationships is an investment in our careers.
Now that I’ve described my decision making and my process, in the subsequent editions of this series, I will outline my framework for reading financial news.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/Fuse
Continuing Education for CFA Institute Members
Robert J. Martorana, CFA, has worked on the buy-side since 1985 as a stock analyst, portfolio manager, research director, financial advisor, and editor of a hedge-fund website. In 2009, Martorana founded Right Blend Investing, a fee-based RIA that manages individual portfolios and does consulting for the asset management industry. RBI has one unique claim to fame in that it supports an orphanage in Andhra Pradesh, India.
Since 2011, Martorana has published over 1,000 pages of contract research, and he is co-author of Alts Democratized by Wiley Finance.