Don’t let intuition (mis)guide your investment thinking - February 2020
Our behaviour as human beings is shaped by a combination of our physiology, biological history, life experiences and the environment. We are unique individuals as a result of our particular circumstances – or so we like to believe.
But one thing we do have in common is the way in which we are wired to respond to adverse circumstances, whether it be fight, flight or freeze; and, it’s safe to say that when challenged, most of us react, rather than make a conscious choice based on more than the current emotion that grips us. The result is that we regularly make suboptimal decisions when confronted with conditions of risk and uncertainty. Think of the last time you responded in anger and lived to rue the day.
Investing, an endeavour that requires long-term, counterintuitive thinking with no upfront guarantee of outcome, is a perfect example of needing to make hard choices in potentially risky and uncertain conditions, where the emotions of fear and greed that are inspired by the prospects of loss and accumulation tend to guide our actions.
But wise investment principles ask us to be bold when we are averse and to be circumspect when we’d rather rush in – in essence we are often called on to be counterintuitive and to act contrary to our instincts. This is not an easy ask.
There are many factors that cause uncertainty – many are beyond our control, so we should master the ones that we can. When investing, one of the biggest obstacles to wise decision-making is our perception of time. We tend to get spooked by recent events, enamored with the next great thing or influenced by long-held and often subconscious biases. And to act on what, in the fullness of time, are but fleeting emotions.
If you are convinced that your level head prevails regardless of the challenges, and I’m not suggesting it doesn’t, consider the pitfalls below and see if there is resonance with some of the common behaviourally-induced misjudgments that may cause you to miss out on achieving your long-term investment objectives. It will serve you well.
As social beings, we share a lot of behavioural traits with other pack animals. Even though we live in a society where we are mostly free to decide what we want to do, we tend to feel more comfortable if we believe and do the same as others around us, we actively seek out similar people that affirm our belief systems. This is known as confirmation bias and is a very pronounced human tendency that is turned to profit by the algorithm-generating tech giants. For this reason, when we are uncertain, we become even more likely to seek confirmation from our ‘tribe’ and to imitate the actions of others. This explains fads and fashions.
The irony is that, in the quest for safety, this pack mentality poses a significant risk to investors, as it often causes crowding into the same popular trades, investments, or funds. And, as more capital starts to chase the same opportunity set, the likelihood of asset bubbles, eventual big losses and potentially extended economic hardship, inevitably increases.
Investors would be wise to remember that group think does not encourage diversity or curiosity, and that what is popular (and therefore comfortable) is not always right. In fact, as in life, in matters of investing at least, we need to think for ourselves and be willing to go against the grain.
A good example of counterintuitive thinking is investors who remained invested in Mondi, a fine paper company whose share price went into decline when glossy magazines and newspapers went out of fashion as the advent of digital disrupted media consumption. The result was a dearth of investment in paper mills.
But as people rushed to cut their losses, they forgot that the same forces that led to the digitisation of media also led to online shopping. Mondi bought some high-quality European paper mills for a bargain, switched to packaging, gained massive market share and did very well. As did the brave investors who did their research, trusted the quality of the management team and held the line.
RECENCY, ANCHORING AND FRAMING
Arguably one of the most damaging behavioural traits for long-term investors is the fact that we are subconsciously influenced by (recent) historical data. If we were fully rational, this information should have no bearing on our decisions, yet it causes us to extrapolate the recent past into the future, expecting that the historical performance of an asset will repeat indefinitely.
As an example, South African equities were lacklustre over the past five years, and more conservative domestic assets delivered better returns. In response, many disappointed investors moved money out of multi-asset funds to take refuge in income funds. This is a perfect example of when the quest for safety informed by recent experience increases discomfort. This switch was return-eroding in 2019, as the timing of reducing exposure to growth assets coincided with an improvement in equity returns.
We prefer making our judgements relative to a reference point (anchoring), often selected from the status quo (e.g. past performance of growth assets). Our perception of value will change if this reference point is moved. This opens us up to being influenced by whoever controls the data (framing) on which we base our decisions.
MITIGATING AGAINST BIAS
No growth, personal or otherwise, can happen within in the confines of a comfort zone. Consider what a seed goes through to become a tree… there is simply nothing comfortable about that.
How does one mitigate against these behaviours? While our emotions and nature may have a negative impact on the investment decisions we make, we would not be human without them. The challenge is not to strive to become something we are not, but to acknowledge when we are in reaction and therefore become aware of when we are susceptible to behavioural misjudgments. This gives us the power and insight to stop and think, and to take the right action – which is most often in spite of our feelings.
In our business, we remain acutely aware of the potential cognitive errors that we are vulnerable to in the process of allocating your capital and are constantly focused on minimising the risk of falling prey to these traps.
Aside from our rigorous proprietary research and engagement with investee companies, one of the ways in which we do this is by inviting differences of opinion in our research meetings. This ensures robust debate when it comes to our investment ideas, making us less prone to confirmation bias and to harness instead the manifold benefits that result from cognitive diversity.
By the same token, investors should be aware that reacting to their intuitive preferences and gut-feel conclusions will often not lead to the best outcomes. If we remain aware of the potential pitfalls, it becomes a little easier for investors to achieve better outcomes. Evidence suggests that giving into fear and greed and constantly moving around – either by switching between asset classes, funds or managers will not serve you well in the long run.
This article was published on Fin24.com