Economic Commentary July 2018


 

“I hate to lose more than I love to win” – Jimmy Connors

World tennis champion, Jimmy Connors, put his success in tennis down to hating to lose more than he loved to win. When it comes to investments, this is also true for many.

 

Studies have shown that the associated pain you feel from a loss is more intense than the reward felt from gain and because of that the average person is only willing to risk a potential loss if they stand to gain at least double that amount.

 

Hating to lose more than loving to win all comes down to two powerful emotions; fear and greed.

 

The Wall Street view is that fear and greed are the main components of what moves the market. Successful investor and multi-billionaire, Warren Buffett, once said that to be rich on Wall Street, you should be greedy when others are fearful and fearful when others are greedy.

 

So why do these emotions have such a high impact on the market and on your investments?

 

According to a number of academics in the field of financial psychology, it has been found that greed, like love, has the power to send a chemical rush through our brains that forces us to put aside our common sense and self-control and thus provokes changes in our brains and bodies.

 

On the other end of the scale, fear stops you from making certain decisions by sending a flight response in anticipation of danger.

 

Fear and greed moving the market was apparent in the late 90s internet bubble and the financial crash of 2008.

 

The internet bubble saw people investing in new internet start-up companies, with the exorbitant prices motivating investors to invest in companies in the dot com domain. This made investors greedy, resulting in securities being heavily overpriced.

 

Then came the financial crisis of 2008. Investors were so fearful of further loss that they took their money out of the market and focused on less uncertain purchases such as the low risk and return securities. Investors were selling stocks and not buying back in fear of losing more money due to the psychological bias of loss aversion. This loss aversion stems from the feeling of loss being more intense than the feeling of gain. 

 

Being too fearful in investing can be detrimental to your portfolio as studies have shown that people who are more risk averse will switch their funds to cash when they’re investment drops rather than awaiting what could be an impending rise.

 

Unlike traditional financial theory would suggest, emotion and psychological bias can cause unreasonable and irrational thinking when making their decisions. As such, there are a number of psychological biases that affect an investor’s decision making in this way; overconfidence and status quo bias being just a small number of them. I will discuss a number of psychological biases in finance below.

Prospect Theory

 

The fear of regretting an investing decision and seeking the pride associated with winning causes a predisposition in investing where investors are selling winning funds too early out of fear that it will lose value and holding onto funds which are losing value because they want to try to get the money back. This psychological bias affects you in the long run rather than immediately.

 

Break-Even Effect

 

Fearing regret and seeking pride goes hand in hand with the break-even effect. This is a psychological bias whereby the investor is willing to risk more funds in order to break-even after losing money.

 

A real life example of this can be seen in the casino. A person could lose £50 but instead of accepting the loss and going home £50 poorer, often they will risk more money in a bid to win their initial loss back. This can lead to losing significantly more than the initial loss and this can lead to a continuous cycle.

 

The feeling of loss causes some investors to panic and just like the example given of the casino, they make the impulse decision to invest more in a high risk fund in a bid to cover their losses. The need for a break-even is often stronger that the pain felt from the initial loss which is why it’s so easy to fall into.

 

Over-Confidence – The Dunning Kruger Effect

 

Over-confidence in ability and knowledge can massively effect investing decisions. This is also known as the Dunning Kruger effect – a tendency for people to think they’re better at something than they are. Research carried out in America found that 70% of respondents (all of whom retail investors) believed they had a high level of financial literacy, whilst 70% also couldn’t pass a basic financial exam.

 

An over-confident investor may find themselves investing large amounts in unsuitable funds simply because they think know more than they do. They may put all of their eggs into one basket by over trading in one fund for this exact reason, which can cause massive loss if that one fund were to drop in value. An over-confident investor may also perceive their actions to be less risky than generally proves to be the case.

 

Status Quo Bias

 

Another psychological bias is status quo bias. The truth is many of us hate change and the fear of the unknown; this is also true for many when it comes to investing. You can become comfortable with that investment you’ve held for years, that has given you a steady gain. The thought of investing in something new which may involve a different process than you’re used to, causes the person stress. People like sticking to what they know and are comfortable with. However, it has been shown in studies that status quo bias reduces profitability and increases risk because people can assume that a fund that they have held for years will continue the same pattern as it always has which is simply not the case.

 

 

 

So how do we apply behavioural psychology to our own investing habits?

 

Applying this is simple – just being aware of our own psychological biases can counteract the problem efficiently. This is because, by acknowledging our biases, we can act upon them.

 

(Jazmine Goodridge; Psychology Graduate, Cardiff Metropolitan University and now a member of the GFP team)

 

And how does this affect our decision making at Gould Financial Planning

Like Jimmy we like winning, but we hate losing more!  Our aim is to develop an investment process that delivers two key fronts; firstly returns!  Risk should be rewarded, and our first aim is to deliver growth.  Secondly, we are looking to achieve these returns, whilst at the same time, reducing risk.  Now these objectives may seem contrary to each other, but this is the challenge the Gould Financial Planning Investment committee sets.

 

What this graph below shows is that for each of our risk profiles (Careful, Cautious, Moderate, Aggressive and Speculative) we are achieving more return for less risk, when we compare our model portfolios to their benchmarks.

 

Gould Financial Planning V Benchmark

Gould Financial Planning v Benchmark

Please note that these performance figures are based on return information provided by Natixis over three year investment periods to the end of April 2018. Platform, product and advice charges are not accounted for; these may typically account for in the region of 0.75% per annum in total.

As you will no doubt be aware, past performance is not a reliable indicator of future returns. The value of your investments can go down as well as up, so you could get back less than you invested.

 

Having taken all of this into account, our “house view” on the various asset classes is unsurprisingly and typically neutral! Please see below for the views of our Investment Committee;

 

Cash & No Risk assets

 

For a long time after the financial crisis inflation was fairly low and holding an overweight position in cash was something we were prepared to follow. However, rising inflation (amongst other things) has made us look towards alternative income funds which we feel are less exposed to the risk of rising interest rates than traditional bond funds.

 

Verdict: Neutral; hold enough cash to meet your needs. Holding more cash than is necessary – particularly over long timeframes – could well see the real value of your wealth erode. If inflation is high and interest rates are low, debts can be inflated away and we have a sceptical view that this status quo will be maintained for as long as the population will tolerate it!

 

Loans & Debt assets

 

We continue to feel that traditional government and corporate debt is fraught with danger. The bubble has grown bigger, and for as long as Central Bankers continue pumping in the air the risk to reward ratio grows further still in favour of the market. It is true that our stance in recent years has suppressed growth, but our view is simple;

 

  • Monies held in this space should be lower risk than equity
  • The risk to capital should be reasonably small

 

We do not feel that the traditional fixed income space satisfies either of the above statements in the current climate.

 

Verdict: Neutral, with the reasoning being to avoid the erosive impact of inflation upon cash assets. However, the focus should be upon assets which are less susceptible to interest rate risk. Floating rate notes, commercial ground rents, flexible mandates and infrastructure debt are the areas we feel can provide an exposure to debt which does not leave you exposed to predictable losses. Of course, losses can still arise – and we no longer feel that the debt markets are as low risk as they once were!

 

Property and Infrastructure

 

Brexit and Labour are the key words where property and infrastructure is concerned! Our long-standing clients will know that we took the decision to reduce UK commercial property exposure in favour of infrastructure 18 months or so ago and this has resulted in underperformance.

 

At the time of writing (22:54 16th July) infrastructure assets have enjoyed a significant recovery – and boy was it overdue! John Laing Infrastructure Fund was subject to a takeover bid from an institutional infrastructure investor at a price considerably above the share price and the result was a well overdue boost in price for the entire sector!

 

We continue to feel that with Brexit on the horizon, physical infrastructure assets are a lower risk strategy than holding Southern-biased commercial property. Of course, political risk is the major concern but whilst John McDonnell may try his best, we do feel that contracted revenue streams afforded by UK infrastructure assets should be secure – even in the event of major political change

 

Verdict: Neutral; bias holdings towards infrastructure which should retain strong investment whatever the makeup of the government!

 

Mixed asset class

 

This is the component of a portfolio that we look towards for relative surety. Managers here have flexible mandates and we want them to utilise these mandates to the fullest!

 

If a sudden need for a cash withdrawal arises during a significant market downturn, we would not be keen to recommend that our clients sell out of equities when prices are on the floor! With this in mind we look towards our Mixed fund managers and, whilst they have underperformed in recent times when the going has been good, we have complete faith in their ability to navigate their way through choppier waters when the going is bad!

 

Verdict: Neutral; ensure that exposure is diversified across different strategies and that there is a clear emphasis upon downside protection.

 

UK Equity asset class

 

The UK equity asset class has continued to deliver exceptional growth, even in the face of one of the most unknown variables – Brexit! To some extent this has been due to the global focus of our stock exchange; however, smaller companies too have continued growing at an exponential rate.

 

Our view is that this cannot continue unabated, and whilst we will always advocate an ample exposure to UK-listed shares for our UK-based clients, we feel that overseas markets are increasingly more important in the grand scheme of a globalised market.

 

The major fear of course is a financial crash. Policy makers have not increased interest rates to a level where they could again be used as a tool against falling share prices, and our currency may also struggle when (or if for the sceptics!) we leave the EU. We therefore question how financial policy could come to the rescue in the event of an arguably overdue correction, and it may well be that fiscal stimulation could be the only way forward.

 

Verdict: Reduced weighting, and take profits from overweight positions. The going has been good - don’t let naivety get in the way of sensible risk management!

 

Overseas Equity asset class

 

Globalisation is making the world smaller, but it is not reducing the benefits of diversification or the advancement of technology upon our everyday lives.

 

As economic growth begins to plateau, we feel there is a chance that growth could be centred upon a smaller number of market sectors. Robotics, cyber security, water and battery storage are four of the themes we feel could dominate the next generation and we have increased our allocations to these areas across the board as a result.

 

President Trump’s fiscal policy is dangerous in our view; inflating a market at the end of a cycle is not typical and whilst his business-friendly approach should be good news for investors, we are concerned that markets may well reject this aggressive stance before time.

Europe too is a risky area in our view. The rise of populism is starting to shape governments in some countries, most notably Italy (the third biggest European economy), and if this trajectory continues we could well be looking at another exit from the EU in the medium term - who knows what the consequences could be if “Itexit” comes onto the agenda!

 

Our stance is to maximise diversification. Passing the day to day management of these problems onto the best global managers is sensible from our perspective. Losses on occasion are unavoidable in this game, but a flexible manager with a proven track record can certainly seek out value when the going gets tough.

 

Finally, the increased consciousness of socially responsible investing is something we are acutely aware of. We have for some time recommended investments into water and renewable energy, and it appears that areas such as this are now drifting into the mainstream. This if of course great news – not least for our children and grandchildren – and we firmly believe that “Environmental Social and Governance (ESG)” investing may well become more and more popular in the years ahead.

 

Verdict: Increased weighting, use the space freed up by the smaller UK exposure to bolster holding in long-term themes such as robotics, cyber security, water and battery storage! At the same time, don’t forget that physical gold is the only thing worth a ha’penny if things turn sour!

 

In conclusion, we acknowledge that the tone of this update may seem fairly negative. It should be remembered that we are not fortune tellers, and neither us nor anyone else in our industry can predict when (or if) a crash might come (even though many will try and kid you otherwise). At the forefront of our mind is managing risk rather than investments; if risk is controlled properly, even the worst of financial collapses will not have too adverse an impact upon your day to day living, and making sure that our clients are looked after in all market conditions is what we are here to do.

 

This article has been written for information purposes only and does not represent personalised advice.

 

 

 






Article published: 31/07/2018

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