Markets across the world have been reaching all-time highs this year.
In bull markets, investors look at any gap between their returns and those of the benchmarks and ask why they have not kept up. But this is only one side of the story.
The behavioural researcher, James Montier found that most people must stand to win at least £2,500 as a possible gain before they will take a 50:50 bet with £1,000 [Behavioural Finance: Insights into Irrational Minds and Markets, 2002]. Rightly or wrongly, humans have an asymmetric attitude to losses known as loss aversion.
Our investment approach for clients is designed with risk at the forefront precisely because of this well-evidenced fact about people’s investment preferences. That’s why the portfolio’s we construct are managed by people whose first question is “what’s the worst-case scenario?” rather than “what if all goes well?”
This “glass half empty” approach makes it possible that returns from clients actively managed portfolio’s may lag the benchmark in strongly rising markets. The reason we are comfortable with this is the maths behind positive and negative returns. A rise of 25% is wiped out by a 20% fall whereas a 20% rise followed by a fall of only 16% still produces a net positive result.
Behavioural finance tells us a great deal about the different, habitual ways people behave. Try as we might to remain cool and rational in our assessment of assets’ return prospects, we are conditioned by our evolutionary heritage to watch like meerkats for signs of danger and we are never more tempted to sell than when storms roll in and newsrooms beam out gloomy news from world markets.
Some think that High-Frequency Trading and other algorithmic systems tend to exacerbate downturns as when prices fall beyond a pre-set tolerance, they are programmed to sell themselves. Thus falling prices ironically beget more sell orders, which swamp the market and push prices down even further.
The human error then kicks in. As investors, we typically discover we are far more sensitive to “downside risk” than anticipated back when our minds were focused on “upside potential”. When we experience losses, memories of that upside potential evaporate and we become consumed by the desire to avoid further regret by getting out of the market as quickly as possible.
It can get worse. Availability bias, our intense recall of the most recent thing we’ve experienced, compounds the problem. We tend to overestimate the odds of another adverse surprise when one has just happened.
Framing the decision
Fortunately, many of us share a behavioural trait which can actually help when voices are calling to sell everything. Loss aversion means people are typically very reluctant to lock in their losses. If you are a nervous investor, consider the chart from JPMorgan below, which should help any of us conclude that sticking with the initial financial plan remains the better option in the longer term, rather than trying to time entry and exit from the markets.
It illustrates exactly why we need to guard against the temptation to sit out market downturns in cash. A primaeval urge to protect what we have can make a material impact on our future prosperity if we stay out of the market even a little too long.
Please note: Past performance is not an indicator of future returns.
Don’t follow the herd
Following the herd gives us greater comfort in the short run, but brings a higher risk of capital loss in the longer term.
This is why we would always recommend submitting to the pain of discipline – so that when screens flash red our clients don’t feel the pain of regret.
“The above article is intended to be a topical commentary and should not be construed as financial advice from either the author or Parmenion Capital Partners LLP. If a client wishes to obtain financial advice as to whether an investment is suitable for their needs, they should consult an authorised Financial Adviser. Past performance is not an indicator of future returns.”
Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation. All investment carries risk and it is important you understand this. If you are in any doubt about whether an investment is suitable for you, please contact one of our financial advisers.