Swedroe: Election Revives Old Myths

November 15, 2016

The results of the U.S. presidential election not only surprised almost all the gurus who were saying that a Hillary Clinton victory was a sure thing, but also those forecasting that, if by some miracle Donald Trump won, a stock market crash was bound to occur. Prior to the election, I had received many inquiries from investors worried about the market and what they should be doing if Trump won the presidency.

It turns out market gurus were right about one thing: The DJIA futures market crashed by more than 800 points in the first moments after it became clear that Trump was going to come out ahead.

Election Day

On Election Day, Nov. 8, the DJIA closed at 18,333. Defying the gurus just two days later, not only had the DJIA recovered from the more than 800 points it lost, but it closed at 18,811. In other words, in just two days it had rallied by about 1,300 points (more than 7%), contradicting many so-called experts who had predicted a 10% or more decline.

I can only wonder what investors who panicked and sold are doing now. It’s highly unlikely, in my opinion, that they will have a good investment experience (unless they either get lucky or learn from it). And there is an important lesson here. It involves the all-too-human problem known as hindsight bias.

On Monday morning, we all make great quarterbacks. With the benefit of hindsight, the right play to call is obvious. Unfortunately, we also have a tendency to exaggerate our pre-event estimate of the probability of a given outcome occurring. To paraphrase Meir Statman, a finance professor at Santa Clara University: Hindsight bias may lead us to believe that even events that the “experts” failed to foresee were obvious—even inevitable.

The way to avoid this hindsight bias is to keep a diary of your forecasts. This might prevent you from remembering only your successes. It will also make you humble about your forecasting abilities, thus avoiding the mistake of overconfidence.

Maybe if those who panicked with the Trump win had kept a diary, they would have avoided panicked selling. Lastly, take the advice of columnist Jason Zweig: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”

Enduring Myths
The election results also brought a second surprise related to one of the many investment myths that persist despite the fact that there’s no evidence to support belief in them. Among the most persistent myths are that the “sell in May” strategy really works, that past outperformance of actively managed funds is a reliably good predictor of future outperformance, and that rising (falling) interest rates are bad (good) for stocks.

The myth that rising rates are bad for stocks and falling rates are good for them exists despite the fact that, over the period 1927 through 2015, the annual correlation of the market beta premium and the term premium on bonds has been 0.007. The zero correlation simply means that sometimes rising (falling) interest rates are good for stocks and sometimes they’re bad for stocks.

Let’s examine what happened. The day of the election, the yield on the 10-year Treasury note had closed at 1.88%. Two days later, it had jumped all the way to 2.15%. Now imagine you had a crystal ball that would have allowed you to see what interest rates would be, but not stock prices. Believing in the myth, surely you would have been a seller. Yet the market had a strong rally.


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