Around the world

10 Avril 2017 Par Valentijn van Nieuwenhuijzen
(Photo: NN Investment Partners)

Markets surround the economy in an effort to facilitate a smooth flow of capital to those parts of the system that can put it to work most productively. They create better access to capital for those with ideas but without savings and improve incentives to allocate the available pool capital efficiently.

Markets have proved to be superior to top-down planning systems in allocating capital in the economy. The history of communism in many countries is making this painfully clear. The more competitive markets are, the better they generally are at this allocation job. In that role markets have contributed a lot to the reduction of poverty and rise social welfare in many places around the world.

Still, there are clear limits to what markets can do. Not everything is tradable in a market and without a market price the incentive to guide the system to a better allocation of resources disappears. Excessive use of “free” resources in our environment, like public space, air or water, is largely out of reach for market forces. Negative externalities from economic activity that influence our climate, our health and the income distribution between and within countries can only be managed through political rather than market channels. And the happiness, compassion, drive and tolerance that design the social fabric on which our economies float remains challenging to steer through market forces. These aspects of life are truly priceless, and probably that is for the best.

Even when there is a market, perfection is hard to find. It might be close to impossible to find a better allocation mechanism, but the theoretically ideal conditions to create a competitive market are hard to find. The combination of rational market participants, homogeneity of market players, full transparency, equal information availability, is often difficult to find in reality. As said, the market mechanism will often still prove to be the best allocation tool in practice, but understanding its limitations helps to both better anticipate how a market will evolve and how to potentially improve its effectiveness.

How to apply these insights in social, economic and environmental matters will differ between these wide ranging topics. Capital markets are just one example where better understanding markets can help to create both a better balanced economic infrastructure and more attractive investment returns for savers. Some of these savers are investors themselves, but often specialised investors are hired to guide investment decisions in the right way. To be able to play this honourable role well and to repay the trust that savers put in these investment specialists, it is indispensable to have a deep understanding of how markets work. What they do well, what they do not, where they are rational and where they are not. Only when you really understand the ecology that you operate in and – very important – are humble enough to acknowledge what you do not know, will you be able to genuinely add value for the savers that trust you with their financial future.

For us it is therefore crucially important to add a behavioural and an innovation flavour to the traditional way of looking at markets. Both at an individual level and at aggregate group level there is ample evidence that decision making by market participants is far from rational all the time. Moreover, that irrationality increases if uncertainty increases. Obviously this helps to explain how erratic markets have behaved in the uncertain times of the last decade or so.

Next to that, players in markets are not a homogenous group. Skills, objectives, sensitivity to regulation and investment styles differ between managers. Also information availability differs or at least the speed at which investors receive it. Furthermore, increasing rather than decreasing returns to scale play a dominant role in how the market is structured and thereby limits the ability of the market to be fully competitive or efficient. 

Therefore we do not only assess how the underlying economic fundamentals are most likely to evolve, which captures where the rational part of the market would like to move. We also aim to map how investor emotion and the perception of uncertainty interact. And how this links into how investors are positioning or where they are moving to, i.e. where flows are going. Moreover how the behaviour of a heterogeneous group of investors translates into a market structure and what that tells us about the fragility in that market ecology.

The market profile that emerges then will not provide a perfect picture either, but does help to better understand the way that markets function.

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