Avoiding value traps, not herding around popular trades and being too overconfident are some of the bad portfolio habits investors should vow to kick in the New Year, according to Mark Tinker, head of Framlington Equities Asia.
Most people start each new calendar year promising to do or abide by certain rules in an effort to improve their lives. The obvious cliché being that these are rarely kept, but why not aim for something better in your investing life?
Looking back to 2015, the potential for both decent returns and harsh losses was very apparent and Tinker thinks by trying to steer clear from certain common mistakes affecting the psychology of portfolio construction could have been beneficial.
In this article, Tinker – with an eye on behavioural finance – sets out the seven resolutions he thinks could bring about greater returns for investors in 2016.
1. Avoid anchoring
‘Anchoring’, in the context of behavioural finance, is illustrated by the idea that if a stock or fund that was priced at say £1 and falls 50 per cent is now cheap based upon that £100 ‘benchmark’, Tinker says.
He says an obvious example in today’s market is oil, which has plummeted over 18 months.
Performance of index over 2yrs
Source: FE Analytics
“Because it was over $100, but is now below $40, the bias is to believe that it should be above $50, perhaps even as high as $70.
“We might doubt the $20 forecasts (not least because they come from the same people that gave us $200 forecasts a few years ago), but a mean between where we are now and where we are ‘anchored’ makes no sense either.”
“Another example is China’s GDP, where anchoring suggests that anything under 6.5 per cent is a disaster because we are anchored on a period of double digit growth.”
2. Avoid confirmation and hindsight bias
Confirmation bias is the tendency to believe what you want to believe and then accept ‘evidence’ that confirms this and ignore anything that contradicts it.
“At the stock level this usually means investing in exciting ‘stories’ and concepts while ignoring the red flags – usually the lack of profitability,” Tinker said.
“At the macro level this can as easily work in reverse, focussing on the negative and ignoring the positive.”
China is another example of this, Tinker says, where very bearish sentiment has increased in the first week of the year.
“Manufacturing Purchasing Manager’s Index (PMI) data is obsessed over as ‘bad’ while the service sector PMI data, which is good and is in fact the whole story we are trying to invest in, is ignored.”
3. Avoid herd behaviour
The next bad habit investors should ditch Tinker says is ‘herding’ around the same markets, stocks or funds without due research regarding the investment case.
“Herding is one of the biggest problems at the market and sector level and is, to a large part, a function of one of the issues discussed last year – the failure to properly measure investment risk and more importantly the incentives for professional investors to herd as a result.”
“Part of the problem in the dotcom era was the fact that fund managers were penalised for moving away from the herd and the bubble was in fact an indexation bubble.”
“Herding as represented by indexation means that markets overshoot due to forced buyers at the top and distressed sellers at the bottom.”
4: Beware prospect theory
Put simply, this is when investors take a bigger risk to avoid a loss than to secure a gain.
The most recent example of this is in emerging markets, where five years of under-performance have led to a capitulation over the past nine months.
“Investors had been reluctant to move first on selling out of EM, even though the relative performance had been terrible,” Tinker said.
Performance of sector and indices over 5yrs
Source: FE Analytics
“They were hoping somehow to reverse their losses, or more importantly not to be the ones that cut at the bottom.”
“However, when the losses became absolute and funds began to see redemptions, the desire to minimise losses kicked in and capitulation ensued.”
5. Avoid over-reaction and availability bias
The combination of ‘herding’ and ‘prospect theory’ leading to such a fall as seen in emerging markets also leads to “over-shooting and over-reaction”, Tinker says.
Studies have shown that ‘bad stocks’ tend to outperform ‘good stocks’ over time because the markets tend to over-react to the news in both directions. This is often called value investing.
Value has been underperforming quality stocks in the UK for several years but many have predicted this is set to reverse sooner rather than later.
Performance of indices over 2yrs
Source: FE Analytics
“This is a good reason to listen to contrarian views, though not a justification to always follow their advice. Being aware of distressed selling is not the same as betting when it will end.”
“Meanwhile, over-reaction can also be extended to over-trading on noise, which is a great way to lose money.”
6: Be careful of overconfidence, of yourself and others
In this context, overconfidence could be believing you are contrarian or dogmatic in ‘anchoring’ in a value trap – but it could also being not cynical enough in the opinion of others.
“Several studies have shown that all investors consider themselves to be average or above despite the obvious logical impossibility of that statement.”
“Recognise that every think tank and expert report has an agenda, most usually to generate more income for the writers. This is not to be cynical, rather to be sceptical.”
7: Beware of the gambler’s fallacy
Last up, Tinker says the gambler’s fallacy is the concept of believing you have a ‘hot hand’, where a random event is assumed to have some predictive power.
This tends to lead to momentum style investing – most evident in China A Shares this year, he says, where volatility has substantially returned after a rollercoaster 2015.
“China A Shares can of course turn extremely quickly and this is a reminder to western investors who tend largely to have an intrinsic mean reversion bias that many investors in Asia, especially retail, tend to be much more focussed on momentum.”
Performance of index over 1yr
Source: FE Analytics
Put simply, don’t expect history to repeat itself.
Happy New Year and good luck with the resolutions!
