EDITOR: | June 29th, 2016 | 3 Comments

Brexit: How the markets made the wrong call

Investor ROI and their amount of social trading
| June 29, 2016 | 3 Comments
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The UK votes to leave the European Union (EU).
The Prime Minister announces his resignation.
$2tn is wiped off the financial markets.
Confusion and uncertainty haunt Europe.

Events like this don’t happen every day. We will be dealing with the consequences, both good and bad, for generations. The interesting thing is that no one really expected this to happen. The markets bet on the UK voting to remain.

The Financial Times quoted one senior fund manager saying: “We never really thought people would vote to leave and now I have to figure out how I am going to get us [his company] out of this bloody mess,” he said, before hanging up his phone to take an “urgent call” with a “very, very large and anxious investor”

Nobody really expected the leave vote to win, and I include myself in this.

All of which has left me thinking, how did everyone make the wrong call?

The day after the result I had a conversation with a colleague and he observed that his network of contacts was primarily positive towards remaining in Europe. I checked this with others and found they were just as surprised. Given that 51.9% of the UK population voted to leave it seems strange that this was not reflected in the informal networks of people I spoke to.

How could the majority vote in a contrary way to the intelligence received through everyone’s contacts?

This situation made me remember some work done a few years ago at the Massachusetts Institute of Technology (MIT) in the United States by Professor Alex Peatland. The work looked at the way investors interacted in social networks, specifically the way ideas flowed between individuals that influenced their decision making behaviour. The MIT team used this and other examples as the basis of their thinking about networks that they called Social Physics.

To help us understand how the markets made the wrong call let’s have a look at findings from the MIT work which looked at the correlation between idea flow and traders’ return on investment. This was a study of a digital trading platform called eToro.

In this network individual traders can make a return from their successful investments as normal. They could also make an extra return based on the number of people that copied their investment decisions because eToro gave them a small reward if they revealed their trades and let other users follow them. This creates a range of decision-making positions. At one end investors could choose to operate alone and use their own market intelligence. At the other end investors could rely entirely on following investment decisions of those traders they perceived as successful. Traders could choose a blend of these positions.

In essence, the MIT team had access to data that showed the degree to which investors relied on their own market intelligence and the market intelligence of others in making their investment decisions – and could relate this to the return on investment of these trades.

They analysed data during 2011 from1.6 million users and 10 million Euro/Dollar trades. This is what they found:

Investor ROI and their amount of social trading

The chart shows that broadly taking into account what others are doing is a good investment strategy – up to a point. Investment returns start to decline when too much attention is paid to what others are doing.

At first sight, dear InvestorIntel reader, you might think that having too much information is a bad thing. It is not quite as simple as that. The reason for the improvement then decline in investment returns, as social trading increases, is due to the quality of the information the traders work with.

isolation and echo chambers in social trading

So, we have a pattern of behaviour driven by how connected people are. It really does matter if you are an isolated individual or someone who pays attention to the wisdom of the crowd without being led astray by the mediocrity of the masses.

What this means for individual investors is that if you are too isolated, you have few opportunities to learn from others and this is reflected in the investment returns. However investors that rely too much on what others are doing become embedded in a network of feedback loops that give a false impression by recycling the same ideas over and over again.

We live in a complex and uncertain world that means we have to make judgement calls. We can manage the risk by trying to triangulate information by calibrating one source with another and looking for patterns. If these different sources are saying the same things then confidence is increased for making a decision in a certain way. The danger in our increasingly interconnected world is that vocal people communicate loudly and frequently to others and this creates an echo chamber where fewer ideas get recycled and amplified and masquerade as diversity of information.

The markets made the wrong call on Brexit because of this echo chamber effect, mistaking the quantity of information for the quality.

So much for the cause. How do we learn from this and do better next time?

There are three things we can all do:

  • Know thyself – When you have confidence in your own knowledge of a situation follow your instincts but also recognise when your individual information is unclear and seek out others in your social network to learn from.
  • Develop and nurture your network of contacts. We are whom we know, to some extent. Networks take time and effort to establish and maintain but reaching out to others is a skill that helps avoid isolation.
  • Tolerate contrarians and avoid oddballs – when everyone is headed in the same direction and saying the same things there is a good chance you are in an echo chamber. Seek out people who are independent thinkers, if there is a contrary consensus amongst them then you have a good chance you are paying attention to wisdom that will help you bet against the flow.

InvestorIntel is a good place to start. I have found my fellow editors to be well connected, smart and independent minded. I have a healthy respect for them and recommend you do too.


Editor:

Adrian Nixon is a Senior Editor at InvestorIntel. He began his career as a scientist and is a Chartered Chemist and Member of the Royal ... <Read more about Adrian Nixon>


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Comments

  • Asher Berube

    “Tolerate contrarians and avoid oddballs” Adrian this is excellent advice getting trapped in an echo chamber can really limit perspectives, In dealing with contrarians it is probably good to look for ones that you trust and seem to show a track record of reliability. – The contrarians I listened to suspected the possibility that England would vote to leave the European Union.

    June 29, 2016 - 12:37 PM

  • Adrian Nixon

    Yes Asher, one contrary voice might be dismissed as an oddball but when several unconnected independent experts have a view that is contrary to the prevailing view you can pay increasing attention because there is a greater chance that the minority view is right and the majority view is wrong.

    June 29, 2016 - 12:43 PM

  • Gordon

    Why the surprise at the Referendum result? After the ultimate sacrifice made by several hundreds of thousands of British and Commonwealth troops, mostly volunteers, spanning the last 102 years fighting foreigners’ aggression and oppression, why would anyone think that our population should meekly allow unelected and unaccountable people to govern the way we live?
    The Brits aren’t as gullible and stupid as the elitist super-powerful NWO types think, nor would it seem are growing numbers of members of EU nationals. Maybe the worm has turned!
    Rule Britannia

    June 30, 2016 - 2:36 AM

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