Tag Archives: Investments

Decoding cognitive biases: what every investor needs to be aware of

By Robert Wright /August 23,2024/

Common human biases that investors should understand when it comes to investing is extremely important. These biases are ingrained in human nature, leading to tendencies to oversimplify, rely on quick thinking or exhibit excessive confidence in judgments, which may lead to investment mistakes. By gaining insight into these biases, investors may be able to make better decisions to help reduce risk and improve their investment outcomes in the long-term.

Numerous cognitive biases can affect how decisions are made. The key to mitigating these biases lies in recognising their presence, identifying when they might arise and then either making appropriate adjustments or obtaining help to moderate their impact.

Seven cognitive biases that might arise at various stages of an investor’s investing journey.

1. Herding: The tendency to follow and mimic the actions of a larger group.
2. Confirmation bias: The preference for information that confirms one’s existing beliefs or hypotheses.
3. Overconfidence effect: Excessive confidence in one’s own investment decisions and abilities.
4. Loss aversion: When the fear of loss is felt more intensely than the elation of gains.
5. Endowment effect: Overvaluing assets because they are owned.
6. Neglect of probability: Disregarding the actual likelihood of events and often overemphasising rare occurrences at the expense of more probable outcomes.
7. Anchoring bias: The tendency to rely too heavily on a past reference or a single piece of information when making decisions.

Herding

The herd mentality occurs when people find reassurance and comfort in a concept that is widely adopted or believed by many others. In recent times, we have seen the herd mentality with the events that surrounded the GameStop stock event. Where many people saw the rise in stock prices and without proper investment research followed the trend of many others and invested.

This impacted a lot of investors who bought the stock due to the fear of missing out and the hype it created. We believe, to be a successful investor, you must be able to analyse and think independently. Speculative bubbles are typically the result of herd mentality. Herd mentality in investing can overshadow rational decision making and could increase the risk of financial losses.

Investors need to recognise the feeling of pressure to conform to popular opinion or follow the crowd and instead consider conducting research and analysis before making decisions, as well as seeking alternative views to challenge the consensus.

Confirmation bias

Confirmation bias is the tendency to favour information that corroborates pre-existing beliefs or theories. In our view, confirmation bias can lead to significant errors in investing. Investors may develop an inflated sense of certainty when they encounter consistent evidence supporting their choices. This overconfidence can create an illusion of infallibility, with an expectation that nothing can go wrong.

Overconfidence bias

Overconfidence bias in investing is where investors overestimate their knowledge, intuition and predictive capabilities, often leading to poor financial decisions. This bias can present itself through various ways such as excessive trading, under-diversification and the general disregard for potential risks.

Investors with overconfidence bias tend to believe they can time the market or have the ability to pick the winning stocks better than most, which in turn may also result in overtrading and increased transaction costs. Overconfidence can also lead to a lack of proper risk assessment and analysis, as investors might underestimate the likelihood of negative events or industry dynamics affecting their investments.

An example of overconfidence bias occurred during the dot-com bubble of the late 1990s and early 2000s. Many investors were overly optimistic about the growth potential of internet related companies. This led to inflated stock prices as more and more people invested in these companies without proper evaluation of their actual worth.

Loss aversion

Loss aversion is where a real or potential loss is perceived as much more severe than an equivalent gain. The pain of losing is often far greater than the joy in gaining the same amount.

This overwhelming fear of loss can cause investors to behave irrationally and make bad decisions, such as holding onto a stock for too long or too little time. For example, an investor whose stock begins to tumble, despite clear signs that recovery is unlikely, may be unable to bring themselves to sell due to the fear of loss in the portfolio. On the flip side, when a stock in the portfolio surges, they may quickly cash out, not wanting to see the possibility of those profits disappearing.

When an investor clings onto failing stocks, departs with successful stocks too quicky and fear governs their investment decision, it’s known as the disposition effect. It’s a direct consequence of loss aversion, leading investors to make overly cautious choices that ultimately undermine their financial goals.

So, understanding this bias may help investors make rational decisions to grow their portfolios while managing risk effectively.

Endowment effect

Closely related to the concept of loss aversion is the endowment effect. This effect arises when individuals place a greater value to items because they own them, as opposed to identical items that they do not own. It’s a cognitive bias where ownership elevates the perceived value of an item beyond its objective market value.

For example, an investor may develop a strong attachment to a particular stock. It could be the very first stock they ever invested in, or they may favour the company for a particular personal reason such as aligning with their values. If this stock begins to fall and financial experts are advising to sell, because of the value bias this investor has they may be unwilling to sell. The investor perceives the stock’s value as greater than what the market dictates, purely because of ownership. It is a delicate balance that is needed to be able to determine between attachment and sound financial decision making and can be challenging for some investors.

To help mitigate the endowment effect, investors should regularly review their portfolios and consider the help of a financial adviser. Establish clear, predefined criteria for selling assets, aligned with financial goals. Develop a detailed investment plan with specific financial goals, a well defined investment strategy is crucial to prevent emotional decision making. Understanding and focusing on long-term investment goals can also help in maintaining objectivity.

Neglect of probability

Humans often overlook or misjudge probabilities when making decisions, including investment decisions. Instead of considering a range of possible outcomes, many people tend to simplify and focus on a single estimate. However, the reality is that any outcome an investor anticipates may just be their best guess or most likely scenario. Around this expected outcome, there’s a range of potential results, represented by a distribution curve.

This curve can vary widely depending on the specific characteristics of the business involved. For instance, companies which are well established and have strong competitive positions, tend to have a narrower range of potential outcomes compared to less mature or more volatile companies, which are more susceptible to economic cycles or competitive pressures.

Another error investors may make is to overestimate or misprice the risk of very low probability events. That does not mean that ‘black swan’ events cannot happen but that overcompensating for very low probability events can be costly for investors.

Anchoring bias

Anchoring bias is the inclination to excessively rely on a previous reference or a single piece of information when making decisions. Numerous academic studies have explored the impact of anchoring on decision making. Typically, these studies prompt individuals to fixate on a completely random number (such as their birth year or age) before asking them to assign a value to something. The findings consistently demonstrate that people’s responses are influenced by the random number they focused on prior to being asked the question.

Looking at a recent share price is a common way investors may anchor their decisions. Some people even use a method called technical analysis, which looks at past price movements to predict future ones. However, just because a stock’s price was high or low in the past doesn’t tell us if it’s a good deal now.

 

Source: Magellan

A guide to active and passive investing

By Robert Wright /August 23,2024/

Investment funds can be broadly split into two categories – active and passive. And while both options play a part in an investment portfolio, it’s important to understand how each works before allocating money to them.

Basics of passive investing

Passive investing has gained momentum in Australia, and beyond, over the last decade. It could be because this style of investing aims to replicate the returns of a particular market index (for example, the S&P ASX 200 Index).

This means, that when the value of the index rises, so too will the value of the fund. On the flip side, as the value of the index falls, so too does the nature of the fund.

Exchange Traded Funds (ETFs) are some of the most popular passive investments. They are similar to managed funds, in that they involve a trust structure which holds a basket of securities. As described above, the investments in the fund replicate the makeup of the relevant market index. For example, if the index is made up of stocks that include banks, mining businesses, retail companies and supermarkets, the ETFs will also hold these stocks.

Units in ETFs are listed on stock markets and can be traded just like shares.

It’s important to note, that while there are also actively managed ETFs, passive ETFs are most common of the two.

Basics of active investing

In contrast, an active approach to investing involves a fund manager choosing the assets in the fund, depending on the manager’s view of markets and the type of fund it is.

Like passive investments, there are many types of actively managed funds which offer exposure to different asset classes and industries. Rather than track an index, an active fund will target a return above a particular benchmark. An example of this is, every year, an actively managed fund might aim to achieve the same return as the S&P ASX 200 plus two per cent. Another common way of measuring the performance of an active fund is for it to target a premium above the rate of inflation. For example, a fund might aim to achieve inflation plus two per cent per year.

Cost benefit analysis: fees

Cost is one of the major differences between these two styles of funds. Typically, passive investments are lower cost, as investors are not paying for the fund manager’s expertise in choosing the investments in the fund.

Active funds, on the other hand typically charge a base fee and a performance fee to incentivise the fund manager to produce the highest possible return.

Market conditions

It’s important to remember that markets will always go up and down, and actively managed funds still have many benefits (as well as risks) while factoring:

• Funds that track an index only produce the return of the index.
• Fund manager skills can be used to pick investments that have the potential to do well when economic growth is slow and markets are falling.
• Active managers can also avoid stocks and sectors that are not doing well.

It’s very difficult to get a true picture of whether actively managed funds perform better over time versus passive funds. It’s probably more instructive to think about how each style of investing is used in a portfolio.

Styles applied

A core and satellite approach are a common strategy investors use that involves both active and passive investing. In this approach, the core of the fund tends to be made up of passive investments that follow the market, while the satellite part of the strategy is made up of more specialised investments.

There are a number of ways this style can be applied, but a popular technique is to use index or passive funds as the core, such as an ETFs that tracks one or more major market indices.

The satellites are made up of actively managed funds that allow an investor to express specific views by selecting their asset exposure. For instance, an investor may choose to allocate funds to an actively managed fund that comprises technology investments, in the belief this sector will perform well. Or an investor may choose to apportion funds to an actively managed gold fund, taking the view this commodity may provide a hedge against market volatility.

There are almost endless ways of using actively managed funds to express views about how different asset classes and sectors will perform over time.

A balanced perspective

There’s really no right or wrong approach when it comes to investing in active and passive investments. Many investors choose to invest in a combination of the two styles to achieve a level of diversification in their portfolios and to get access to a broad range of asset classes across the risk spectrum.

 

Source: BT

What is risk appetite?

By Robert Wright /May 28,2024/

Risk is about tolerating the potential for losses. Understanding your risk appetite allows you to make well informed decisions about your money.

For some people, risk means excitement and opportunity. For others, it invokes feelings of fear and discomfort. We all experience a degree of risk in our everyday lives – whether it’s simply walking down the street or having investments in the share market. Everyone has a risk profile that defines their willingness to accept risk. It’s usually shaped by age, lifestyle and goals and is likely to change over time.

Risk is about tolerating the potential for losses, the ability to withstand market movements and the inability to predict what’s ahead[1]. In financial terms, risk is the chance that an outcome will differ from the expected outcome or return. It includes the possibility of losing some or all of your original investment[2]. Often you may not be aware of your risk appetite until you’re facing a potential loss, so loss aversion becomes a significant factor when making decisions related to risk.

What is risk appetite and risk tolerance?

Risk appetite and risk tolerance are used interchangeably but are different.

Risk appetite is a broad description of the amount of risk an investor is willing to accept to achieve their objectives. It’s a statement or series of statements that describes their attitude towards risk taking[3].

Risk tolerance is the practical application of risk appetite3 and considers the degree of variability in returns an investor is willing to bear.

As an investor, you should have a good understanding of your attitude towards risk. If you take on too much risk, you might panic and sell at a bad time. But if you don’t expose yourself to enough risk, you may be disappointed with your returns and potentially unable achieve your objectives.

How do I work out my risk appetite?

Think about how you might answer these questions:

• How much money do I have to invest?
• How much money am I willing to lose?
• How worried would I be if share markets fell dramatically?
• Am I planning to track your investments daily?
• Would I consider investing in different types of investments?

Your age, income and investment objectives all help determine your risk appetite.

Age: generally younger investors with a longer time horizon to invest are more willing to take greater risk with their money to earn higher potential returns. Older investors with a shorter investment timeframe may be more cautious as they’ll need their money to be more readily available and have less time to recover from a loss.

Income: people who earn more money and have a higher disposable income can typically afford to take greater risks with their investments.

Investment objectives: be clear about why you’re investing and when you think you’ll need to withdraw your money, as well as how long you need the money to last. Saving for a holiday or a deposit on a home is quite different from investing for your retirement.

Risk and Return

The relationship between risk and return underpins all financial decisions. The more risk an investor is willing to take, the greater the potential return. However, investors expect to be compensated for taking on this additional risk and should realise that taking on more risk doesn’t guarantee higher returns.

What type of investor are you?

• High: willing to risk losing more money for the possibility of better returns.
• Moderate: willing to endure short-term loss for the prospect of better long-term growth opportunities.
• Conservative: willing to accept lower returns for a higher degree of liquidity or stability.

Whatever your risk appetite, you should always consider both risk and return before making decisions about what to do with your money. Although shares and property are generally considered to be higher-risk investments, even more conservative investments like bonds can experience short-term losses. No investment is completely risk free.

This explains why smart investors typically have a diversified portfolio that includes several different types of investments.

Risk and Diversification

Don’t think that just because your friends invest in shares you should too. If you don’t have a lot to invest or you’ll want to access your money in a few years, shares may not be the right type of investment for you.

By understanding your risk appetite and being honest about what you want to achieve, you’re more likely to be comfortable with your investment decisions. A financial adviser can help you understand your risk appetite, as well as create a portfolio that suits you.

The simplest way to minimise investment risk is through diversification. A well diversified portfolio will usually include different asset classes, like shares, property, bonds and cash, with exposure across different industries, markets and countries. The idea is to reduce the correlation between the different types of investment and have a good balance of assets which move in different directions and at different times. So, if some of your assets perform poorly, others may be performing well, offsetting the poor performers.

Although diversification doesn’t guarantee you won’t suffer a loss, it’s an effective way to minimise risk and help investors realise their financial goals.

Make informed decisions

You should monitor both your risk appetite and your investment portfolio over time.

Your risk appetite is likely to change as you get older, and as your income or family situation changes.

Similarly, you should review your portfolio to ensure the risk level is still suited to your overall investment objectives. Financial markets are constantly changing, which means the underlying assets you’re invested in could change too.

If you’re a confident investor, you should check that it’s still on track to generate the level of return you want and importantly, at a comfortable level of risk. If you prefer to speak with a financial adviser, they too can help you undertake regular reviews and rebalance your portfolio, as necessary.

By understanding your risk appetite, you’re in a better position to make well informed and transparent financial decisions. It will help you identify opportunities to take on more risk where appropriate or see where you’re exposed to unnecessary risk and adjust accordingly. You’ll also avoid being caught up in the emotion of market activity, where panic can lead to a poorly timed and costly decision.

 

[1] Charles Schwab: How to Determine Your Risk Tolerance Level https://intelligent.schwab.com/public/intelligent/insights/blog/determine-your-risk-tolerance-level.html.

[2] Investopedia https://www.investopedia.com/terms/r/risk.asp.

[3] Australian Government Department of Finance: Defining Risk Appetite and Tolerance https://www.finance.gov.au/government/comcover/education/risk-appetite-and-tolerance.

 

 

 

Source: BT

Will cash remain king?

By Robert Wright /May 28,2024/

Cash has been one of the best performing defensive assets over the past three years. When compared with global bonds (a riskier asset class), a typical portfolio of term deposits would have returned a cumulative 12.6% in comparison to -8.5% for global bonds over the three years to December 2023. With interest rates expected to stay higher for longer, cautious investors would be right to question whether other asset classes are worth the risk. But are the tides changing?

On paper cash still appears to be king; however, these healthy returns are attributed to accelerated inflation and rising interest rates, an environment we may be moving away from. Inflation has been trending downwards for months and rate cuts are predicted to begin before the end of 2024.

In this paper we explain why we believe now is a good time to revisit your asset allocation.

What is a bond?

A bond is a loan made by an investor to a borrower, generally a company or government. Typically, the borrower pays the investor interest (coupons) periodically over the term of the loan and then returns the initial value (principal) of the loan back to the investor at an agreed upon future date.

Bond values are linked to the borrowers perceived ability to pay back the loan as well as interest rates. For example, when interest rates rise, newly issued bonds offer higher coupons, making them more attractive and equivalent existing bonds with lower coupons less attractive, reducing their value.

How do bonds differ from term deposits?

Bonds are expected to provide higher returns over the long term because investors require compensation for assuming investment risk. Bonds also provide the opportunity for capital growth as well as higher income. This compares with term deposits where interest payments are lower but guaranteed by a bank – providing more security. Whilst income is guaranteed, the real value of a term deposit often diminishes over time due to inflation, which erodes your purchasing power (figure 1).

 

 

 

 

Figure 1 also shows that bonds are subject to greater risk over shorter time horizons which means they won’t be suitable for everyone. Your initial investment can go down in value and when you invest in funds this can be offset through the distributions, reducing your income. This primarily occurs when interest rates are rising and become unpredictable as they have in recent times.

Investors need to determine, with support from their adviser, whether trading term deposits capital guarantee for the potential increased return of a bond investment is suitable to their circumstances.

Why now?

In an environment where inflation is trending down and rates are expected to be cut, long term bonds should perform well as this is the environment when you typically experience the most capital growth (see figure 2). Term deposit rates are also forward looking. In other  words, you don’t need to wait for central banks to reduce cash rates before you start to see term deposit returns fall. There are already signs of this happening. Whilst  very recent, 1-year term deposit rates came down by 0.05% in January and we expect this trend to continue (although this won’t necessarily be a smooth journey). Whilst seemingly insignificant, this could be meaningful for larger investors. Particularly where capital growth has no role to play and investors don’t require the capital guarantee of cash.

What happens if the economy deteriorates?

If a recession were to occur, interest rates are more likely be cut quicker to encourage spending, resulting in bond prices rising. This would be supported by increased demand as investors move away from higher risk assets such as equities. If we don’t enter a recession and achieve a soft-landing scenario, rates will likely trend down more slowly to bring inflation in line with central banks’ targets; once again favouring bonds due to the inverse relationship between interest rates and bond values.

 

 

 

 

 

 

Conclusion

We believe it is critical to take a diversified approach to investing to help manage portfolio risks through different market conditions. The balance and mix of assets will depend on each investor’s ability and willingness to take on investment risk as well as how much of their capital they need guaranteed.

That said, we believe now is a great time to be reassessing your asset allocation. Investors looking for capital growth who don’t need capital guarantees should consider introducing bonds into, or back into, their investment portfolio and doing so before central banks begin to cut rates.

While cash rates may seem alluring, it is important to remember the distinct roles bonds and cash play in a portfolio. Cash is best reserved for short-term spending needs that require a guarantee as it will not provide the long-term capital growth and inflation protection of other assets.

It may seem daunting as we have been through a period of significant market volatility but over the long term, we have high conviction that bonds will provide better risk adjusted return outcomes for investors who are able to take on the increased risks offered by bonds.

As always, we recommend speaking to your financial adviser to get tailored advice based on your unique circumstances prior to making any investment changes.

 

Source: Perpetual