Since the industrial revolution, humans have made many advancements which changed the way we live. Modern life is full of new claims of similar life altering changes, such as: technological breakthroughs, changes to the demographics of a population or changing interest rates.
As investors, we need to evaluate these developments and decide whether we are going to re-allocate some of our finite capital in an attempt to benefit from these potential changes or not. However, investors typically struggle to accurately evaluate the impact that these changes will have on the economy and investment markets.
Why is it so difficult? Are people not smart enough?
Roy Amara was an American computer scientist, futurist and President of the Institute of the Future. He famously coined the following adage, that was to become Amara’s Law:
“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.”
The reason may be that we tend to think that the effect of change occurs in a straight line (the sum of its components) instead of an exponentially increasing curve (the product of its components).
This may be rooted in our everyday life experience, which is mostly the sum of its components, while change is comparable to interest on interest (compounding) which is the product of its components.
The above graph reflects the inherent flaws investors make when attempting to predict the trajectory and consequences of technological advancements.
When applying Amara’s Law to investments, we can observe a similar pattern in how investors often perceive the short-term and long-term impact of various investment strategies, market trends, and individual investment decisions.
- Short-Term Overestimation: In the short-term, investors may be prone to overestimating the immediate impact of market events, such as: economic indicators; earnings reports; or geopolitical developments. There can be a tendency to believe that these factors will have a more significant and immediate effect on investment performance than they actually do. This can lead to reactive decision making based on short-term market fluctuations and may even cause these fluctuations.
- Short-Term Disappointment: Following the initial overestimation, investors may experience short-term disappointment when market events or individual investment decisions do not deliver the anticipated immediate results. The market can be volatile, and investment performance can fluctuate in the short-term, leading to feelings of frustration or dissatisfaction.
- Long-Term Impact and Realisation: Over the long-term, the impact of market trends becomes more evident. Investors who take a longer-term perspective and stay committed to their investment strategies are more likely to realise the true potential of their investments. Market trends and economic cycles tend to play out over longer time frames, and the compounding effect of investments becomes more pronounced.
- Transformation and Exceeding Expectations: Just as technologies often have a transformative long-term impact, investments can also bring about substantial changes and exceed initial expectations over time. Successful long-term investors understand the power of compounding returns, the benefits of diversification, and the importance of staying invested through market cycles. Over the years, well-chosen investments and sound strategies can accumulate wealth and achieve long-term financial goals.
The companies listed on the US NASDAQ represent a great number of world leading technology companies. The graph below shows how Amara’s Law is evident in the NASDAQ’s returns. The light grey line shows the straight-line change while the dark grey line shows the exponential change.
Some of the changes that had and will continue to have a great impact on our environment are shown. There are certain advancements which have since fizzled out, while others revealed gaps which highlighted additional areas for potential innovation. In the case of artificial intelligence (AI), as progress was made, the inadequacy of computational power was highlighted; mobile devices and electric vehicles (EVs) sparked further development of battery technology.
How could one apply the framework to investment decision making?
Let’s look at Artificial Intelligence (AI).
What can we learn from applying this framework to investments?
- The critical element is to get the direction of change right.
- Changes to our environment tend to have a greater impact over the long-term, supporting a long-term investment time horizon.
- There might be a period in the medium-term where you question your investment case for a certain view as the market might have over-reacted and is now under-reacting. As long as the fundamental view and time horizon have not changed, remaining committed to your strategic allocation is crucial to benefit from the compounding effect.
Applying Amara’s Law to investments reminds us of the importance of taking a long-term view and avoiding overreacting to short-term market fluctuations or individual investment performance. By recognising the tendency to overestimate short-term impacts and underestimate long-term effects, investors can make more informed decisions, focus on their long-term goals, and stay committed to sound investment strategies.
