There is a reason why few individuals make the history books as truly great investors – it is called human instinct. Whilst the ‘greats’ can often take on star like status, we all know that wishing on that single star doesn’t always end well. So we need to understand how to overcome the powerful forces of human nature at play in our portfolios.
Wealth preservation or self-preservation?
Most investors save and invest with a long horizon in mind. This unfortunately does not always mean that they make investment decisions to optimise their long term goals. Buying the best performing funds and selling them after the first drawdown to buy the latest best performing funds is a good example of the dichotomy between long term goals and short term investment decisions.
Fund managers have their own issues too (and no, I don’t feel that sorry for them either). They might be accused of ‘benchmark hugging’ if performance fails to sparkle (so as to prevent a rush to the door). Not so much wealth preservation as self-preservation.
They might be pilloried if their high conviction, contrarian approach falls out of favour. Either circumstances can be an uncomfortable place to be.
Human behaviour
Other human behavioural biases have to be considered too. A lot has been written on this topic, which became particularly popular after the publication of Daniel Kahneman’s book, Thinking, Fast and Slow, in 2011. When making decisions, people, most of the time, use mental shortcuts and rules of thumb, which can generate sub-optimal outcomes. Fund managers are not immune to these natural human behaviours. Below are a few examples:
- Overconfidence
A common human trait, which is probably particularly pronounced among fund managers is the belief that positive outcomes are a reflection of their ability and skill, while negative outcomes are bad luck. After a prolonged period of good performance (coinciding with a long bull market perhaps), this can lead to overconfidence, an increase in risky and concentrated bets and, finally, a potentially significant drawdown.
- Disposition effect bias
Academic research has shown that in general investors tend to sell winners and hold losers. The fear of not crystallising a win, along with the associated regret, induces investors to sell high performing stocks prematurely. On the other hand, the hope that a loss may recover induces investors to hold on to poorly performing investments. While experience and some rigour in the investment process should mitigate the disposition effect of professionals, such natural behaviour cannot be excluded.
- Anchoring and availability bias
Recent and past experiences (particularly if traumatic) strongly influence people’s decisions. After a big market crash, investors tend to overestimate the likely occurrence of another imminent crash. Ten years later, the effects of the global financial crisis is still palpable: at every market correction many investors and financial pundits advocate the beginning of another severe crash similar to – if not worse than – the one experienced in 2008.
- Naïve diversification
Evidence suggests that many fund managers use an oversimplified approach to diversification, which can potentially lead to unwanted exposures to particular risk factors and consequently unexpected results. An equally weighted portfolio, for instance, where every asset in the portfolio has the same weight, can have a disproportionate exposure to smaller companies, particular sectors or domestic businesses.
Taking human instinct out of decisions
It is not surprising that so many investors, recognising these problems, have chosen to opt for passive strategies. There may be no opportunity for outperformance over the benchmark, and in fact they are guaranteed to underperform the market net of fees, but those fees are small and so they should track benchmarks more closely and consistently.
There is, however, another approach – the systematic investing model (which some call ‘smart beta’). Systematic funds are built using mathematical algorithms and econometric models, trade automatically, aiming to capture alpha by focusing on a more selective group of stocks within a broad index or set of indices.
Though almost as cost effective as passive investing, systematic investing takes some of the principles of active management, but without the negative drag of behavioural biases. Impassionate systematic strategies may even be tilted to try to exploit the irrational nature of financial markets, recognising, for instance, when stocks have been oversold.
While the market cap weighting of many passive funds can leave investors highly exposed to certain stocks, a systematic investment model can be more balanced and focus on factors such as company fundamentals (quality), earnings (growth) and price (value).
According to astronomy, those who wish upon a star are already a few million years late – that star may have long since gone. Whilst it might be harsh to apply that analogy to the cult of personality in the fund management industry, there’s certainly no room for stars in the world of systematic investing.
Nor is there room for emotion. Systematic managers might be silently weeping behind their machines if markets are tough, but it will have absolutely no impact at all on the portfolio!
