There are seven types of behaviour that lead to mispricing of companies and opportunities in markets that all investors should be aware of, according to Merian Global Investors’ Ian Heslop.
Heslop, who is Merian’s head of global equities and manager on the £1bn Merian Global Equity fund, said that the post-financial crisis bull run has seen the recurrence of some behavioural biases among investors.
Such behaviours, however, can lead to opportunities, particularly when large number of investors are behaving in a similar fashion, for those that are aware of these ‘deadly sins’ and know the best ways of exploiting them.
Below, Heslop outlines the ‘seven deadly sins’ of behaviour all investors should be aware of.
Herding
The first issue that investors should pay attention to is herding, which Heslop said has been seen in the violent short-term trends of recent months.
Herding, he said, leads investors to panic and sell after the market falls and buy at the top of rallies.
“It reminds me of a film called The Breakfast Club – it’s not often you get to use a teen film in a presentation – I remember the adolescents in school and the principal utters one of the great lines ‘Don’t mess with the bull, young man, you’ll get the horns’,” he said.
“And I think at the crux of that is the real issue that we have within markets right now: understanding when is momentum an opportunity for us, but also – as importantly – when is momentum dangerous.”
He added: “It’s very difficult to be a contrarian investor in an environment where everybody is moving in one direction and it much harder to take a decision not go into that direction.”
As such, Heslop said investors should take a calm, long-term perspective, have confidence in the judgements backed by evidence even when it is contracted by others’ short-term behaviour.
Loss aversion
The next deadly sin is loss aversion, said Heslop, who noted that a loss is often felt more keenly than the pleasure of a profit.
The Merian manager said that after several years of low volatility prior to 2018, many investors had forgotten how to handle losses.
Performance of S&P 500 since 30 September 2018
Source: FE Analytics
“We feel negatives more than the positives, and we’ve seen that over the past couple of months,” he explained, noting that the painful end to 2018 may have prevented some investors from taking part in the sharp rally seen at the start of the year.
To combat this, the global equities head said investors should adopt a broader view, setting losses in the context overall long-term profits.
Confirmation bias
The third behaviour highlighted by Heslop is confirmation bias, which he said managers are often guilty of unconsciously filtering out data that would contradict existing beliefs.
“As fund managers we have more data than we know what to do with,” he said. “And part of our role is finding out what’s relevant and what is not.”
To prevent this, investors need to adopt a systematic approach based on a disciplined and objective methodology when analysing data.
Anchoring
Another documented deadly sin is anchoring, in which investors rely heavily on one piece of information, according to Heslop.
Such a bias might be seen in the belief that some asset classes are safe havens, such as utilities, real estate, Japanese yen or gold. However, the Merian manager said all were negatively correlated to the CBOE SPX Volatility VIX index during 2018.
Performance of index since 31 December 2016
Source: FE Analytics
“We can see anchoring in returns in how an asset class trades relative to one another,” he said. “Trying to find assets that behave well in a higher volatility environment has been very difficult.”
Investors can avoid this by considering objectively as much up-to-date information on as possible when making investment decisions, said Heslop (pictured).
Endowment effect
The endowment effect causes investors to value something they own more highly than something they do not, said the Merian Global Equity manager.
This can lead to investors holding onto underperforming stocks for too long and prevent them from forming a fair value of their investments.
Instead, Heslop said investors should view themselves as temporary holders of stocks and use them to take advantage of changes in the market environment.
“We rent stocks, we don’t buy them,” he explained. “Stocks move in and out of the portfolio based upon whether they do a job for us or not. There’s no conversations about being held for another week.”
Conservatism
Being unwilling to change your beliefs when presented with a new situation can lead some investors to be guilty of conservativism, the Merian manager said.
One such example is the belief that value should outperform growth over the long term.
Despite some evidence to back this up, it will have come as little comfort to investors in recent years as the loose monetary conditions in place since the financial crisis have helped fuel the rise of growth assets.
Investors guilty of such inflexibility would have been missed out on some of the significant returns on offer from the growth style in recent years. “It’s really important the you note a change in leadership and that the actual structural environment is changing,” he said.
Overreaction
The last deadly sin highlighted by Heslop is the potential havoc that can be caused by an excessive emotional response to markets and can lead investors to abandon their processes, particularly after a period of underperformance.
The return of volatility in 2018 highlighted this risk after a relatively benign 2017 may have led to some overreaction last year, as was seen in the market sell-offs at the end of the first quarter and during the fourth quarter of the year.
“It’s very inherent upon us to take a sober view when we see markets changing,” said the global equties manager. “Spending more time [focusing] on the past 12 months while avoiding the real returns that we’ve seen over the past 18-20 years is a risk.”
Heslop said remaining flexible on investment style while continuing to follow the investment process that leads to decisions is one of the best ways of preventing this risk.
Heslop has managed the four FE Crown-rated Merian Global Equity fund since November 2007, latterly with Amadeo Allentorn and FE Alpha Manager Mike Servent.
Performance of fund vs sector & benchmark under Heslop
Source: FE Analytics
During his time on the fund, the strategy has made a 191.70 per cent total return, compared with a 153.18 per cent gain for the MSCI World index and a 102.38 per cent return for the average IA Global peer. It has an ongoing charges figure (OCF) of 1.00 per cent.