Tag Archives: Investment Strategy

Booms, busts and investor psychology: Why investors need to be aware of the psychology of investing

By Robert Wright /November 28,2022/

Up until the 1980s the dominant theory was that financial markets were efficient. In other words, all relevant information was reflected in asset prices in a rational manner.

While some think it was the Global Financial Crisis that caused faith in the so-called “Efficient Markets Hypothesis” (EMH) to begin unravelling, this actually occurred in the 1980s. In fact, it was the October 1987 crash that drove the nail in the coffin of the EMH as it was impossible to explain why US shares fell over 30% and Australian shares fell 50% in a two-month period when there was very little in the way of new information to justify such a move.

It’s also hard to explain the 80% slump in the tech heavy Nasdaq index between 2000 and 2002 on the basis of just fundamentals. Study after study has shown share market volatility is too high to be explained by investment fundamentals alone. Something else is at play, and that is investor psychology. 

Individuals are not rational

Numerous studies by psychologists have shown that people are not always rational and tend to suffer from various lapses of logic. The most significant examples are as follows. 

Extrapolating the present into the future:

People tend to downplay uncertainty and assume recent trends, whether good or bad, will continue.  

Giving more weight to recent spectacular or personal experiences in assessing the probability of events occurring:

This results in an emotional involvement with an investment strategy. If an investor has experienced a winning investment lately, he or she is likely to expect that it will remain so. Once a bubble gets underway, investors’ emotional commitment to it continuing steadily rises, thus helping to perpetuate it. 

Overconfidence:

People tend to be overconfident in their own investment abilities. 

Too slow in adjusting expectations:

People tend to be overly conservative in adjusting their expectations to new information and do so slowly over time. This partly reflects what is called “anchoring” where people latch on to the first piece of information they come across and regard it as the norm. This partly explains why bubbles and crashes in share markets normally unfold over long periods.

Selective use of information:

People tend to ignore information that conflicts with their views. In other words, they make their own reality and give more weight to information that confirms their views. This again helps to perpetuate a bubble once it gets underway.

Wishful thinking:

People tend to require less information to predict a desirable event than an undesirable one. Hence, asset price bubbles normally precede crashes. 

Myopic loss aversion:

People tend to dislike losing money more than they like gaining it. Various experiments have found that a potential gain must be twice the potential loss before an investor will consider accepting the risk. An aversion to any loss probably explains why shares traditionally are able to provide a relatively high return (or risk premium) relative to “safer” assets like cash or bonds. 

The madness of crowds

As if individual irrationality is not enough, it tends to get magnified and reinforced by “crowd psychology”. Investment markets have long been considered as providing examples of crowd psychology at work. Collective behaviour in investment markets requires the presence of several things:

A means where behaviour can be contagious:

Mass communication with the proliferation of electronic media is a perfect example of this. More than ever, investors are drawing their information from the same sources, which in turn results in an ever-increasing correlation of views amongst investors, thus reinforcing trends. 

Pressure for conformity:

Interaction with friends, monthly performance comparisons, industry standards and benchmarking, can result in “herding” amongst investors. 

A precipitating event or displacement that gives rise to a general belief that motivates investors:

The IT revolution of the late 1990s, the growth in China in the 2000s and crypto currencies more recently are classic examples of this on the positive side. The demise of Lehman Brothers and problems with some crypto currencies/markets are examples of displacements on the negative side.

A general belief which grows and spreads:

For example, a belief that share prices can only go up – this helps reinforce the trend set off by the initial displacement.

Bubbles and busts

The combination of lapses of logic by individuals in making investment decisions being magnified by crowd psychology go a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and get positive feedback via the media, their friends, etc). Of course, the whole process goes into reverse once buying is exhausted, often triggered by contrary news to that which drove the rise initially. 

What does this mean for investors?

There are several implications for investors. 

First, recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of investors. The key here is to be aware of past market booms and busts, so that when they arise in the future you understand them and do not overreact (piling into unstable bubbles near the top or selling everything during busts and locking in a loss at the bottom). 

Second, try and recognise your own emotional responses. In other words, be aware of how you are influenced by lapses in your own logic and crowd influences like those noted above. For example, you could ask yourself: “am I highly affected by recent developments? Am I too confident in my expectations? Can I bear a paper loss?” 

Thirdly, to guard against emotional responses choose an investment strategy which can withstand inevitable crises whilst remaining consistent with your financial objectives and risk tolerance. Then stick to this even when surging share prices tempt you into a more aggressive approach, or when plunging values suck you into a defensive approach. 

Fourthly, if you are tempted to trade, do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. Extremes of bullishness often signal eventual market tops, and extremes of bearishness often signal bottoms. Successful investing requires going against the crowd at extremes. Various investor sentiment and positioning surveys can help. But also recognise contrarian investing is not fool-proof – just because the crowd looks irrationally bullish (or bearish) doesn’t mean it can’t get more so.

Source: AMP

Alternative Thinking: Diversifying Beyond Traditional Asset Classes

By Robert Wright /November 28,2022/

Once a staple investment allocation, the traditional balanced portfolio of shares and bonds has had some challenges in delivering positive returns in today’s market environment.

Institutional investors, such as superannuation funds and endowments have been investing in alternatives for many years and it is a rapidly growing asset class in the global investing landscape. Individual investors are now looking to alternative asset classes to help diversify their portfolios and improve the probability of meeting their long-term objectives.

What are alternative assets?

Alternatives cover a broad range of asset types, which can include almost anything that does not fit into traditional, market-traded equity and bond securities. These include assets such as real estate, infrastructure, shares in private companies, private loans and debt, as well as alternative trading strategies, such as hedge funds and absolute return funds.

Why invest?

Each of these sub-categories can have very different risk and return drivers to each other as well as to traditional equities and bonds. By including an allocation to these asset classes, the diversification benefit can improve the expected risk-adjusted returns of the portfolio as a whole. 

It is important to note that these asset classes are less liquid and more complex than traditional equities and bonds. Whilst it’s expected to generate additional returns or better risk outcomes for investors; the illiquid and private nature of many alternative assets generally suit investors with a longer investment time horizon.

We consider them appropriate for investors with a minimum investment horizon of five years and recommend a moderate portfolio allocation of 5-20% depending on the investment objectives of the portfolio.

Not all alternatives are the same

For most investors, a diversified allocation covering a wide range of alternatives can lead to better outcomes over the longer term. Illiquid or private assets mean that investment managers can take advantage of inefficiency or less transparent asset prices to generate more skill-based, idiosyncratic returns.

Conservative or more cash-flow based valuations can provide more portfolio stability and less sentiment driven ‘noise’ compared to the daily ‘mark-to-market’ price returns in equity and bond markets.

Alternative trading strategies can generate returns, even when markets are declining in value, by selling stocks ‘short’ or using other types of derivative instruments. Overall, these assets and funds can contribute to better returns, reduce volatility and build in more downside risk protection for portfolios.

The right mix and allocation of alternatives will vary, and the benefits of these asset classes also come with a different set of risks to consider which may not be suitable for all investors.

Source: Perpetual

What alternative assets bring to your super investment mix

By Robert Wright /November 17,2021/

Most of us have heard of the main asset classes: shares, property, fixed interest and cash, but alternative assets are less well known. However, these types of assets can provide further diversification and enhanced returns for your super.

Alternative investments are those found outside the traditional asset classes. Typical ones include real estate, private equity, venture capital, infrastructure, renewable energy, hedge funds, commodities, and private debt.

Generally, these are assets that aren’t correlated to the performance of the sharemarket, that is they can often perform when sharemarket returns are down or flat.

The net result is that alternative investments add an extra layer of diversification – you’re not ‘putting all of your eggs in one basket’ and seeing all asset class suffer at the same time.

Low returns pique interest in alternatives

In the current low interest rate environment, which tends to mean lower returns for cash and bonds, alternative investments can help members grow their super to retire comfortably.

Alternative investments differ to publicly available funds as they’re part of the private investment market and aren’t easily accessible for individual investors. They typically include:

Infrastructure

Infrastructure assets are known for providing long-term, stable and predictable cash flows. Opportunities can be found within energy production and transmission but are also emerging in newer sectors such as agriculture infrastructure and renewable energy, particularly wind-powered energy and a selection of solar-power opportunities.

Private equity

The private equity sector invests in companies that are not publicly traded. The advantage is that by investing at the start of a company’s lifecycle, it’s possible to generate strong risk-adjusted returns and benefit from high earnings growth when compared to listed markets.

Real estate

Real estate has a low correlation to shares but is often considered to be a good hedge against inflation. The asset class has evolved over time to include publicly listed and real estate investment trusts (REITs) that include data centres, childcare and storage facilities, as well as commercial real estate debt, which provides loans to commercial borrowers who need funding for real estate purposes.

Performance can lift when using alternative assets because alternatives are generally less impacted by daily market movements in the way that other assets are. Shares and bonds can be quickly affected by changing market, social and economic events, such as the COVID-19 pandemic for example. Therefore, the overall volatility, or the ‘roller-coaster ride’ of increasing and decreasing valuations, should reduce when funds include a proportion of alternative assets in the mix.

Not all alternatives are equal

Of course, alternative assets need to be carefully researched and reviewed in order to find the most appropriate options for each particular fund. They need to be carefully weighed up against other asset classes and sectors to ensure the most appropriate levels of risk and reward that will support investors to achieve a comfortable retirement.

Source: IOOF

Learning the lessons of 2020: An extraordinary year

By Robert Wright /June 11,2021/

When the COVID-19 pandemic hit Australia in March 2020 it brought immediate and severe financial gloom. Shares plunged 37% and the economy slumped to its first recession in nearly 30 years. However against that backdrop, 2020 turned out far better for diversified investors than initially feared.

The development of vaccines became the good news of the second half of 2020 and offered hope of a return to life as normal. The anticipation of economic recovery, paired with ultra-low interest rates, drove a rebound in many investment markets and we did see a strong growth rebound in the second half of the year.

In 2021, we expect to see solid returns as markets shift from pandemic winners to cyclical investments, but the gains will likely be slower than seen coming out of the March pandemic lows of 2021.

For investors, 2020 was better than feared

The list of negatives brought about by the COVID-19 pandemic cannot be ignored. Unemployment surged, with severe disruption to industries like airlines, retail and the office sector. Globalisation took a further blow and tensions rose with China. Public debt skyrocketed. However there were a number of key positives.

The massive fiscal support provided by governments shielded businesses from collapse and saved jobs and incomes. Debt forbearance schemes headed off defaults, while plunging interest rates helped borrowers service loans.

Economies began to reopen after social distancing helped contain the virus, with nations like Australia, New Zealand and Asian nations doing better on this front than the US and Europe.

The November 2020 election of US President Joe Biden offered the prospect of less global policy uncertainty and reduced international tensions in 2021 and beyond.

Disruption caused by the pandemic massively accelerated a number of broader productivity gains. These include the faster take up of technology like virtual meetings, e-commerce and use of the cloud to cut costs and boost output for business.

As a result, the pandemic has shown it is possible for people to work from home and enjoy a more balanced lifestyle – increasingly in regional areas where property prices are generally more affordable.

The benefits of science – typified by the rapid development of vaccines – has also served as a rebuke to populist politicians and offers hope for better management of issues like climate change in the future.

The lessons of 2020

• Timing market moves is hard – getting out at the top of the share market in February 2020 was hard, but getting onboard again for the rally in March last year was even harder.
• Don’t fight the central banks – while they could not prevent the magnitude of the fall in share markets, their massive money easing was a key driver of the recovery.
• Investment valuations need to be assessed relative to interest rates – low rates make shares relatively attractive.
• Depressions can be avoided – 2020 showed that a large, rapid, well-targeted economic policy response can protect an economy from a significant shock and enable it to rebound quickly.
• Turn down the noise – stick to a long-term investment strategy.

Reasons for optimism through the remainder of 2021

Recent bumps in the road of vaccine roll out has not stifled the overall goal of achieving herd immunity in many developed countries by the second half of this year. Fiscal stimulus and easy monetary policy continue to work through the system, with even more fiscal stimulus being injected into the US economy. Continuing high saving rates indicate significant spending potential as confidence improves. Low inflation, and hence low interest rates, mean we are still in the “sweet spot” of the investment cycle.

After having run up so hard since early November 2020, shares are still vulnerable to a short-term pull back. We are likely to see a continuing shift away from investments that benefitted from the pandemic and lockdowns (technology, health care stocks and bonds) to investments that benefit from recovery (resources, industrials, tourism stocks and financials).

We expect global shares to return around 8% this year, but we anticipate there may be a rotation away from tech-heavy US shares to more cyclical markets in Europe, Japan and emerging countries.

Australian shares are likely to be relative outperformers returning around 12%.

Australian home prices are likely to rise 10-15%, boosted by record low mortgage rates and government incentives, but the pause in immigration and weak rental markets will likely weigh on inner city areas, and units in Melbourne and Sydney.

Nine things for investors to remember

• Harness the power of compound interest – under the principles of the ‘Rule of 72”, it takes 144 years to double an asset’s value if it returns 0.5% p.a, but only 14 years if the asset returns 5% p.a.
• Don’t get thrown off by the cycle – investors can often abandon a well thought out strategy at the wrong time during falling markets – as some may have done in March last year.
• Invest for the long term – get a plan that suits your wealth, age and risk tolerance and stick to it.
• Diversify – don’t put all your eggs in one basket.
• Turn down the noise. As discussed earlier.
• Buy low, sell high – the cheaper you buy an asset, the higher its prospective return, and vice versa.
• Beware the crowd at extremes. Don’t get sucked into the euphoria or ‘doom and gloom’ around an asset.
• Focus on investments that you understand. It’s probably best to avoid companies that have complex and hard to understand valuations or business models.
• Accept it’s a low nominal return world. Historically, when inflation is around 1.5%, the average return of 7% for super funds begins to look pretty good.

Source: AMP Capital