Tag Archives: Investments

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

Active versus Passive Investing – What’s the difference and what’s the best?

By Robert Wright /September 08,2022/

Investing in shares is a popular way of helping people to achieve their long-term financial goals. These investments can generate favourable returns over time as companies grow and improve their profitability. Dividends paid by listed companies can also generate a useful income stream.

However, there are also risks associated with investments in shares. Companies (or stocks) that struggle are likely to see their share prices fall and share markets as a whole can be affected by periods of economic weakness or unexpected events.

All investments carry risk, including those in professionally managed funds. However, exposure to shares in such funds may be one way that investors can navigate the volatility in markets. These funds are usually well diversified, spreading investment risk across a wide range of companies. There are two distinct types of funds available to investors – active funds and passive funds.

What is Active Investing?

Most actively managed funds aim to outperform a particular index – for example, the S&P/ASX 200 Accumulation Index, which represents the top 200 stocks listed on the Australian share market. The intention is that the combined portfolio of shares will perform better than the relevant index, which is often used to ‘benchmark’ or measure the performance of stocks.

Investment managers of funds have access to the information and research necessary for completing detailed analysis on companies traded on the index. As qualified professionals, they can identify the stocks likely to outperform the market average over time. With robust investment processes not readily available to individuals, active investment managers draw from their industry experience and analysis to buy and sell shares in an effort to maximise returns for investors. They buy stocks that are expected to perform better than the broader market, sell winning stocks following a period of favourable performance, and avoid those that are expected to underperform.

Of course, investments can experience day-to-day fluctuations, and there is also a risk that active funds will underperform compared to the benchmark if the selected stocks do not perform as well as investment managers anticipate. While the value of a benchmark fluctuates from day to day, the extent to which returns vary from those of a benchmark can be an indication of a manager’s skill.

What is Passive Investing?

A passive investment manager tries to replicate a share market index, such as the ASX 200, by owning shares that make up the index. The quantity of each stock held is determined by the stock’s weight in the index. For example, if BHP Billiton accounts for 6.7% of the ASX 200, a passive fund manager will invest 6.7% of the fund in that stock, and so on, for every stock in the index. The investor should expect returns to be close to that of the market index.

Which Type of Fund is Right for You?

One approach is not necessarily better than the other. When deciding on a preferred style of investment, investors should first consider their investment objectives, return targets and how much they want to pay. Many investors expect to receive returns that are above that of a market index and may therefore prefer investing in an actively managed fund. In this case, choosing an active investment manager can be important and a key consideration for investors is their confidence in a manager’s ability to achieve their investment objectives. While past performance is not necessarily an indication of future performance, most investors will consider a manager’s long-term performance track record before making an investment in a fund.

Cost can be another differentiator of the two styles. Actively managed funds typically have higher management fees to cover the cost of research and to pay for the employment of experienced analysts as part of the fund management process. In contrast, management fees for passive funds tend to be much lower. That’s because no attempt is made to outperform a benchmark index through research or stock selection.

Source: Colonial First State

Five Questions to ask before Plunging into an ETF

By Robert Wright /September 08,2022/

Exchange Traded Funds (ETFs) have been available on the ASX for over 2 decades, but in recent years, this category’s variety and representation within Australian portfolios have grown rapidly.

By offering exposure to different global markets, industry sectors and strategic themes, as well as non-equities asset classes like bonds and commodities, ETFs can provide relatively low-cost “building blocks” for a diversified portfolio.

However, as with any investment, it’s very important to understand what you are putting your money into, and to ensure that it suits your specific needs.  Here are five questions to ask yourself, or your financial adviser, before you purchase an ETF.

Question 1: Does it accurately capture the market exposure that I want?

You wouldn’t judge a book by its cover, so make sure to look beyond the ETF’s name to properly assess the underlying exposure of the product. Common misunderstandings include:

• Mistaking a “picks and shovels” exposure, through owning suppliers and supporters of a sector, for that sector’s output. For example, a portfolio of cryptocurrency miners and exchange operators is not the same as a direct investment into cryptocurrency;
• Confusion between ETFs linked to a commodity’s spot price, which is the price for immediate delivery, and those representing a futures curve, which will move with expectations for longer-term pricing; and
• Overlooking exchange rate movements, which can influence your returns from anything not priced in Australian dollars. This impact can be neutralised with a currency-hedged ETF.

Question 2: Is the exposure active, passive, or somewhere in between?

Early ETFs were purely passive, usually linked to an equities index like the S&P/ASX 200, but now, there are also actively managed portfolios within an ETF structure. “Smart beta” portfolios which apply rules-based investment strategies are becoming more common too, for example, one might invest in a basket of stocks which screen well on quality factors. The exposure type affects fee levels and return potential, with passive ETFs tending to be the cheapest, but lacking the potential to outperform an index benchmark.

Question 3: How liquid is this product?

It is possible for the price of an ETF to diverge from that of its underlying exposure, particularly in volatile market conditions such as the COVID-19 panic in early 2020. To ensure that investors can get in and out of a product when they want to, ETF providers often employ a Market Maker, an institution which quotes separate prices to buy and sell units.

Generally, ETFs with a smaller pool of units on issue are more likely to have poor liquidity, and this can show up in a wide spread between the buy and sell prices. Using “at-limit” orders when trading ETFs can help ensure that you receive the price you expect.

Question 4: How does the fee compare to alternatives, and what are the trade-offs?

Low cost is a major benefit of ETFs, but when you have several to choose from, it’s worth understanding why one’s management fee is cheaper. Active management usually costs more, and ETFs linked to a major market benchmark are sometimes priced higher because the index provider takes a cut of the total fee. Unusual products may carry a scarcity premium, while new or smaller-scale offerings may have lower fees, both to compensate for their initially poor liquidity, and also to entice more patronage over time.

Question 5: How does it fit with the rest of my portfolio?

Any new investment should be considered in the context of your existing portfolio. ETFs can provide valuable diversification, but they can also be a source of inadvertent overlap or concentrated exposure to certain sectors or factors. For example, ETFs linked to the S&P 500 index, the NASDAQ 100 and an actively-managed global growth strategy might overlap in high exposure to the Big Tech stocks, so this combination might not provide adequate diversification.

Source: Lonsec