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By Thobela Mfeti, 20 September 2016
With political and economic uncertainties being the drivers of markets, there is no clear direction as to what markets will do going forward. The instability in oil prices has been a strong theme - resulting in volatility in commodity prices and energy companies’ stocks. As a result of slower economic growth, especially in developed markets, we saw central banks intervene through accommodative monetary policies. The Federal Reserve reviewed its outlook from four rate hikes this year to just one, and in the first half of the year, they did not raise rates as a result of disappointing US economic data. The Bank of Japan (BOJ) introduced negative rates where commercial banks are charged for holding deposits. Through this mechanism, the BOJ wanted consumers to spend more, thereby stimulating inflation.
The main highlight was Brexit, when the British voted to leave the European Union. Britain’s main stock exchange, the FTSE 100 lost 3.15% by close of the following session and a further 2.55% the following day, only to recover a few days later.
Locally, we are experiencing the effects of the worst drought in more than a century and this has had a negative impact in terms of growth and inflation. South Africa’s inflation has been above the upper target of 6% since the end of 2015 and our GDP came in at a negative 1.2% in the first quarter of 2016. While we were given a reprieve by the ratings agencies in June, the risks of a downgrade still remain, especially with the instabilities in governing institutions and the disputes between the finance minister and the Hawks.
There are many other factors that will move our markets in the months to come, with the implications of Brexit still unclear and China still a concern. The US is also at centre stage as the Fed believes that the US economy may be strong enough for an interest rate hike.
The past two quarters could be seen as an indicator of what the year ahead will be like - volatile. Investing according to an appropriate risk profile and staying invested for the entire investment time horizon becomes really important, now more than ever.
In such volatile times, managing investors’ common reactions and decisions, which are often based on biases, is important. It is impossible not to be biased in decision-making, but in order to mitigate potentially incorrect decisions, it is important to identify investors’ biases and create rules to avoid them. These behavioural biases may result in irrational financial decisions caused by faulty cognitive reasoning or influenced by feelings. There are two types of behavioural biases; cognitive errors and emotional biases (eds. CFA Level III, 2015).
Cognitive errors are basic statistical, information-processing or memory errors that result in the decision deviating from being a rational one. These are mental conflicts arising from new information that contradicts existing beliefs. Because these errors stem from faulty reasoning, better information, education and advice can often correct them. Emotional biases, on the other hand, are spontaneous, as a result of attitudes and feelings - which result in decisions being irrational. They stem from impulse or intuition, are often personal and sometimes based on unreasonable judgement. They are therefore not easy to correct. It is important to recognise an emotional bias and adapt it (eds. CFA Level III, 2015). This means that the bias is accepted and decisions made recognise and adjust for it rather than eliminate it. Let us now look at both cognitive errors and emotional biases in a bit more detail, in order to understand the types of biases investors are often exposed to.
This is when an investor answers a question differently based on the way in which it is asked. As a result, risk tolerance may be misidentified which could result in suboptimal portfolios. An investor may be risk-averse when presented with a gain-frame of reference or risk-seeking when presented with a loss frame of reference, as they consider themselves to have nothing to lose (eds. CFA Level III, 2015).
To detect the framing bias, one should ask if the decision is based on a net gain or loss reference. However, intermediaries should refrain from using loss or gain references but rather focus on future prospects of the investment.
This is when an investor maintains their past views or forecasts despite new information. Individuals with conservatism bias overweight their initial belief about probabilities (likelihood of things happening) and under-react to new information; they do not modify their beliefs and actions with new information. This can result in a delayed reaction to the information.
Conservatism can be corrected or reduced by proper analysis and weighing of new information. Investors should ask questions such as “How does this information change my goals/forecasts and what impact does it have on my investment goals.”
This is when investors look for and notice that which confirms their beliefs and ignore or underweight that which contradicts their beliefs. This can also be viewed as selection bias. In this instance, investors may only consider positive information and ignore negative information. This can lead to under-diversification (highly concentrated portfolios), which could result in higher risk. Actively seeking information that challenges existing belief systems may reduce or correct for conservatism.
This is when an investor classifies new information based on past experiences and classifications. Under this bias, a view is likely to be adopted with new information, based on a small sample. For example, investors may hire and fire managers based on short-term performance as they only consider short-term performance to be normal and discount past, long-term performance. To overcome this bias, it is recommended that historical performance (for example, 10 years) of all the asset classes is presented to investors so that their decisions are not solely based on recent performance.
This is when investors choose easily available outcomes and unconsciously assume that a readily available thought, idea or image represents an unbiased estimate of statistical probabilities. This can result in decisions being influenced by media, failure to diversify, and failure to reach an appropriate asset allocation. It can also result in a limited opportunity set.
An appropriate investment strategy, a disciplined research and analysis process with a long term focus will help eliminate this short-term over-emphasis.
According to this bias, money earned from different sources is treated differently and is therefore also invested differently. Mental accounting may result in investors placing investments into distinct buckets without accounting for correlations between asset classes across these buckets.
This can be seen where investors have different savings vehicles; for example, retirement savings, emergency savings or education savings. When these are placed in separate vehicles, their effect on each other is ignored which may result in over-exposure to a particular asset class or stock.
To combat this bias, investors should consider an investment summary which shows all the different investments and asset allocations on a look-through basis. This will help avoid asset class concentration.
This is when investors believe they can influence or control outcomes when in actual fact, they cannot. This can result in excessive trading, over-diversification and highly concentrated positions in companies that investors feel they have control over. This hindsight bias feeds the illusion of control negatively, where investors may see past events as being predictable and reasonable to expect.
Investors need to recognise that successful investing is a probabilistic activity (eds. CFA Level III, 2015) which may not be fully predictable. It is important to seek different views before investing and also keep records of investment decisions including the reasons behind them. This will help the investor see whether they can predict the market or not.
This is when investors prefer avoiding losses as opposed to achieving gains. According to studies, psychologically, losses are significantly more powerful than gains. This means that investors feel the pain of loss more than the joy of gains. They’re therefore more concerned about losing money when markets fall than growing it when markets climb. While it is not possible to make the experience of losses any less painful, a disciplined approach to investing based on fundamental analysis should help identify probabilities of future losses and gains.
This is when there is a conflict between short-term satisfaction and the achievement of long-term goals. Under this bias, people fail to act in pursuit of their long-term overarching goals because of a lack of self-discipline.
Here, proper investment planning and personal budgeting is key to long-term investment goals. Recording, reviewing and seeing these plans through is important in achieving long-term investment goals.
Recency bias is evident when investors buy into a stock, asset class, region or fund because of its current or recent rally. The belief that the investment will continue to rally supports this bias. This can also be linked to the availability bias which is a cognitive bias.
Longer-term data should be considered to put the present environment into context. A consistent and research-driven investment process is key. Exposure to financial media should also be carefully managed as it can exaggerate the impact of recent information (Amert, 2013).
Now that some common biases are clearer, let’s explore what biases were evident in a recent study conducted by Kamil Maharajh, Investment Analyst at Glacier, and published 27 November 2015.
Maharajh conducted a series of studies on chasing performance as an investment strategy in the multi-asset income category. These studies proved that investing in a fund as a result of its recent past out-performance is not a prudent investment strategy.
This was based on the annual returns over 10 years until the end of 2014. Maharajh worked through each year’s performance data and picked the best performer from the previous year, investing it for the next year, doing so over and over for 10 years (Chasing 1 strategy). A two-year holding period was also tested. Here, the fund was held for two years before switching to the best performer in the previous year (Chasing 2 strategy). These are short-term performance-driven strategies where investors are essentially chasing the best performers. They were then compared to a strategy where the investor invested into any of the funds with a 10-year history in 2004 and remained invested in them for the entire period (Buy and Hold).
These were the funds in his study and their annualised performances since 2004:
Graph 1: Buy and Hold versus Chasing investment strategy
Graph 1 illustrates the performance of the Buy & Hold strategy versus the one-year chasing performance strategy. A positive bar indicates that the Buy & Hold strategy out-performs while a negative bar indicates that the chasing strategy outperforms. This is calculated by taking the accumulated investment amount after 10 years on the Buy & Hold strategy and dividing it by the accumulated investment amount after 10 years on the chasing strategy.
The Coronation Strategic Income Fund was then identified as a quality fund and R100 000 was invested at the beginning of the 10 year period. At the end of the 10-year period, the Buy & Hold strategy delivered R245 907.68 (9.42% p.a.). The Chasing 1 strategy, which chose the best performing fund each year and invested in it, delivered R229 141.38 (8.65% p.a.) over the same period. In essence, the Buy & Hold strategy, using the Coronation fund, for the same 10-year period returned 7.32% more than the Chasing 1 strategy (Maharajh 2015).
This study proved that buying and holding a quality asset manager’s fund outperformed the strategy which chased performance. It is important to note that this study did not take switching costs, capital gains tax events trigged by switching between funds and other related costs into account, which could make the chasing strategy seem even less attractive. Maharajh also conducted the same study on the General Equity and High Equity categories reaching similar conclusions.
Maharajh (2015) concluded that the ability to withstand short-term volatility and remain invested in the markets proves to be prudent and rewarding, especially when invested in established, highly experienced asset management houses with proven track records.
While the study advocates holding quality managers for longer, it also highlights how biases may impact decision-making: some of the obvious biases evident in the chasing performance strategy are:
Identifying biases that investors may have can assist in managing expectations and ensuring that they are invested in line with their profiles. It is therefore important to always check whether investment decisions are aligned with investor’s financial goals. A long-term, focused and a consistent research–driven approach to investing is the best defence in terms of combating behavioural biases.