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Staying the course: acting rationally in irrational markets

“Probably the most significant and pervasive characteristic of the human pleasure machine is that people are much more responsive to negative than positive stimuli” – Amos Tversky, 1990

By: Andrew Duvenage – NFB Financial Services Group

After nearly five years of almost mono-directional, upward market movement, December 2015 through to February 2016 have provided investors (in both local and foreign markets) a reality check. The disconnect between economic realities and market levels, caused by loose global monetary policy and stimulus, has been bought into sharp focus, with significant sell offs in equity markets and a rout in emerging market currencies. The fact that risk and return are related, and that there actually is a downside to risk, was reinforced in no uncertain terms. South Africans have had the added dynamic of added uncertainty (and associated volatility) resulting from South Africa specific issues – namely “Nenegate”, constitutional court challenges, budgetary issues and the dark looming cloud of a credit rating downgrade.

The result of a reality check, such as the one recently experienced by markets, is the understandable desire to act – to do something. This desire to act often results in irrational behaviour from investors and market participants. In times of uncertainty it is certainly difficult to be philosophical, but at times like these, it is wise to revisit certain fundamentals of investing before making rash decisions and having knee-jerk reactions.

An interesting framework to use to do this is provided by some of the constructs of behavioural finance, which deal with some of the myths and truths of investing, and how they impact on investor psychology and ultimately behaviour. Given current market conditions and investor uncertainty it is worth considering some of these myths and truths:

Investment myths

  • We can predict the future

The behaviour of the market over the past few years has had the effect of making many investors overconfident. In reality, it is very difficult (if not impossible) to predict the future. The converse is also true, in that during times of volatility, losses can make investors overly pessimistic about the future. Both of these dynamics influence our behaviour.

  • We can time markets

All investors would like to be able to buy low and sell high every time that they make an investment decision. The reality is however very different. It is only with hind sight that we can see where the peaks and troughs of markets are. Investors should not focus on timing the market but rather time in the market. During times of extreme volatility, the temptation to try and sell out and wait for the market to drop further so that one can time the bottom is very much an exercise in futility.

  • Investing is a competition

People tend to compare themselves to others and often behave in response to the behaviour of others. Thus, people are prone to making the mistake of “herding”. Investing is an individual exercise.

  • Past performance is an indicator of future performance

In many cases, investors make decisions based on what has happened in the past, but not on the fundamentals that are going to drive performance going forward.

  • Market commentaries are useful

Everyone is entitled to have a view. And almost everyone does. The result is often that because a plethora of views, theories, and “tips” are forced on the investor by various forms of media, it becomes difficult to separate “noise” from useful information. “As information doubles, knowledge halves and wisdom quarters” (source unknown).

 

Investment truths

  • We can’t predict the future

Investors must understand that they can’t predict or always correctly time the market. Following a rational, predetermined investment framework, over a sustained period of time, will invariably result in more favourable investment outcomes that speculatively buy and selling to catch peaks and troughs in the market.

  • Investing is a means to an end

Investing should not be looked at in isolation. Investing should be one part of a comprehensive financial plan. By understanding the eventual outcome that an investor is trying to reach, the likelihood of making rational and appropriate decisions will be maximised.

  • Investing principles are enduring

In markets, abnormalities are normal. Markets will go up and markets will go down. Decisions must not be made on the basis of emotional, knee-jerk reactions but rather on the principles and truths of investing.

  • Understanding investment risk helps decision making

Towards the end of a bull run, investors tend to lose sight of the relationship between risk and return. By having a clear understanding of the risks involved in a specific investment or strategy, the investor improves the likelihood of making rational decisions.

  • Investor behaviour is the greatest determinant of future performance

The investment decision that one makes now, and the process through which these decisions are arrived at, are the most important factors that will determine future performance. Being rational in irrational times is vital.

  • Time frame is vital

In times of volatility, short termism is a real danger. The desire to focus on short term market moves is understandable, but ill advised.


Easier said than done?

Whilst the myths and truths discussed above may seem great in theory, how does one implement them in a practical investment strategy?

  • Set your financial goals,
  • Calculate the required real rate of return required to achieve these goals,
  • Examine the asset allocation that would be required to reach this rate of return,
  • Assess the risk attached to this asset allocation and
  • Adopt the investment strategy or adjust your financial goals.

 

“The irony of obsessive loss aversion is that our worst fears become realized in our attempts to manage them.” – Daniel Crosby

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