Base rates and the right side of history, Part 1 – with Dan Rasmussen

Investors should look to develop a sense of historical probabilities around an idea by comparing it to other analogous points, rather than just building a very specific narrative about what is going on right now

27/06/2021

Ben Arnold

Ben Arnold

Associate Investment Director, Equity Value

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

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The idea history is no guide to the future has become something of a cliché in the world of finance – and yet it is a brave investor who chooses to ignore completely the lessons history has to offer. That said, as deep-value investor and author Dan Rasmussen points out in a recent episode of The Value Perspective podcast, there are ways to use history to help us make better decisions – and there are ways not to do so.

“The way not to use history is to build up a compelling narrative about what is going on and what is therefore going to continue to go on,” he warns. “Don’t go, for example, I have studied the ‘software as a service’ market deeply, I am convinced it is ripping out enterprise software, that growth is going to continue, recurring revenue is the best type of revenue and this is such a powerful economic force, it will continue forever.

“What you will have noticed about all that is it is very recent history – I have used a lot of very specific ideas to make a lot of very specific forecasts. What is missing is any concept of probability and any acknowledgement of the broad sweep of history – that a long period of time has been studied. What you want to do instead is look at a long series of historical events.

“So instead of focusing on software as a service, let’s say I want to study innovations. I want to look at big innovations that affect an entire sector – and I want to look at that over 100 years. I can then ask, how long does the stockmarket reward those big innovations – and then what happens when it stops rewarding them? And, ultimately, is betting on those innovation waves a good thing? That is a base rate-driven approach.

Sense of historical probabilities

“That way you can identify what percentage of the time it does and does not work and the ups and downs of when it does and does not work. And you are starting to develop a sense of historical probabilities – or base rates – around an idea by comparing it to other analogous points in history, rather than just developing and building on a very specific narrative about what is going on right now.”

To Rasmussen’s mind, value investing is much more driven by this base-rate view of the world. “What we see with investing is that technological innovations come and they go,” he explains. “And when they come, they are adopted by others, they get competed away, there is excessive optimism and talent and money flow into the most interesting – and overvalued – sectors. Ultimately, it flows in too much, too fast and leads to crashes.

“As an investor, then, what you want to look at is places with capital scarcity – where do people not want to put money that is offering me a reasonable reward for putting money there? Obviously things trend – those fashions can work for a period of time – so it is smart to incorporate that into your thinking as an asset allocator.

“You have to have other parts of your portfolio – you cannot just be a value investor – so you have to take trends into consideration because they can last a while and make you look really bad if you ignore them. It is quite clear from studying the long sweep of history, however, that investing in places with capital scarcity is what makes money in markets.”

Key economic drivers

According to Rasmussen, investors must also think about the key drivers of economic outcomes – essentially growth and inflation – and the effects they have had in different combinations and across different decades. “Given we know we don’t know what will happen, but we want to be prepared for any set of conditions that could happen, how should we then think about asset allocation and investment decisions?” he asks.

“This is where a pure back-testing approach can often mislead us. Back-testing fits a particular pattern of random events – that we went ‘growth, growth, growth’, say, not ‘growth, inflation, stagflation’ – so our back-tester decides the best methodology is X. What we really want to do, though, is step back from that and consider the core drivers.

“What is the fundamental logic underlying our thesis about the way the world works? Are we being agnostic to the things that might have happened randomly? We can then use probabilities to determine the likelihood of the possible outcomes in a better, more sophisticated way.” We will look at how Rasmussen suggests investors incorporate base rates into their analysis and process in The right side of history – Part 2.

Author

Ben Arnold

Ben Arnold

Associate Investment Director, Equity Value

I joined Schroders in 2016 after spending 3 years as an analyst at the Royal Bank of Scotland. I them moved in to the Value team in January 2018 as an investment specialist after working for two years in Schroders' Distribution division. I am a CFA Charterholder and hold an MSc in Corporate Strategy from The University of Nottingham.

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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