Our behaviour is dramatically shaped by bombardment of financial news and opinions, particularly at the beginning of each year (so called expert forecasts) and during times of financial tumult.
Inherently, we may know that we should be greedy when others are fearful and fearful when others are greedy, but we are also receiving very powerful messages and cues in the form of commentators and "experts" telling us that the "end is nigh" and when we look at our quarterly portfolio statements.
If we don't have decisional constraints in place, it is easy to be lured into making wrong decisions!
Our capacities for intense focus and restraint are limited and today's moderation sows the seeds for tomorrows excesses (ask the person on a very restricted diet, when they binge-eat at the first possible opportunity!) - that's why we need to create habits and processes.
As in all areas of life: Motivation is what gets you started, habit is what keeps you going!
For investing, that is even more ob obvious:
It is extremely difficult and draining to be conservative in the face of a bullish market or to snatch up bargains during a panic.
So difficult, that anybody would fail if they had to make those decisions every day (think of your struggles in deciding what to wear very day!) that, unless an investor has a process and a discipline to follow the process with exactness, he/she is prone to fail.
An analysis by various authors (Gary, Vogel and Foulke, DIY Financial Advisor, p.23) found that investment models equal or beat expert decision-making a startling 94.12% of the time, meaning that human discretionary decision making was superior only 5.88% of the time.
All the research corroborates the fact:
If you are using human judgement instead of a process to make investment decisions, you are doing extra work with diminished results!
The solution is in designing and abiding by an investment process that is as much as possible resistant to behavioural decision making errors.
(Consider this: With all the knowledge that you have, you should NEVER lose your temper with your kids, skip exercise or overeat, if emotions had no overriding effect. Education is no substitute for emotional guardrails).
When looking at financial markets and the stock market in particular, we generally have to deal with three types of risk: systemic, unsystematic and behavioural.
Systemic risk refers to market risk, ie losing money from broad market moves. This risk cannot be diversified away and examples include natural disaster, acts of terrorism, etc.
Unsystematic risk refers to the individual business risk and reflects the risks of an individual business going down in value. This risk can and should be hedged against through diversification, ie owning more than one company from more than one business sector.
Behavioural risk refers to the fact that YOUR own actions increase the probability of 'permanent loss of capital'.
In brief, therefore, systematic risk means the failure of markets, unsystematic risk the failure of business and behavioural risk means the failure of SELF.
Of these, we can control the last two, unsystematic risk and particularly behavioural risk which, in my humble opinion represents the single biggest reason why most investors (private as well as institutional) fail in making great returns over time.
As the behavioural risk is so important, this weeks blog goes into more detail here. According to Dr.David Crosby ("The Laws of Wealth", p.135), behavioural risk can be split into 5 categories:
overconfidence and the defending of own decisions. It manifests itself in overly concentrated portfolios and/or excessive leverage.
The investor is unaware of her own bias and often has a preference for known risks over unknown risks. He/she is often slow to adopt new information when it arises and generally this the future looks the same as the past.
The perception of risk is influenced by our shifting g emotional state and our individual tendency towards positivity or negativity. This is why generally the financial advisors risk profiling tools do not work very well, as investors give different answers at different times, depending on their emotional state at the time of answering the questionnaire.
This risk reflects our tendency to give more weight. to "low-probability-high scariness " risks like being in a terrorist attack, while ignoring
"high-probability0-low-scariness":risks, such as eating at McDonalds (The fact that you do not immediately drop down with a heart attack does not distract from the long term danger of eating g highly processed foods!)
It also includes the tendency to rate the "unfamiliar" as more risky and give preference to "familiar" names, regardless of fundamental qualities.
5. Conservation risk:
This reflects the fact that we have a tendency to have asymmetrical preference for gain, relative to loss and
we tend to prefer the status quo relative to change.
We prefer winning to losing and the "old way" to the "new way".
It is often evidenced by selling 'winners' too early and holding g on to 'losers' for too long.
Based on the above, investment strategies THAT WORK tend to be low fee, diversified, low turnover AND taking into account behavioural biases.,
The reliable way to combat behavioural risk is to 'create a simple process that accounts for each behavioural risk" AND to follow that process UNFAILINGLY!
This requires a process orientation instead of a goals orientation.
Therefore, you should set out your investment process with all the required parameters and then follow it, independent of the behaviour of the general market.
Let's look at a simple, but effective example, by looking at the Lapis Global Top 50 Dividend Yield Fund (acknowledgement: The author is personally invested in the fund and has a personal interest in it. It is used here for information purposes only and DOES NOT CONSTITUTE A SOLICITATION TO BUY OR SELL THE INVESTMENT!!! Investors are urged to do their own due diligence and/or seek professional advice, before making any investments)
The Lapis fund is rules based and thereby excludes subjective behaviour.
It invests in 50 global companies, that are equal weight in the fund. Each company has a minimum $25bn market capitalisation and a minimum of 25 years of uninterrupted and continuously increasing dividend payment. The annual management fee for the fund is 0.45%.
The selection criteria of all eligible companies (about 150) to get to 50 is undertaken as follows:
50% weight is given to the dividend yield
25% weight is given to the market capitalisation of the company
25% weight is given to the compound annual growth (CAGR) of the dividend of the company over the last 5 year period.
The fund is then rebalanced every quarter.
These are fairly simple rules and there are other funds and ETFs (Exchange traded funds) which have more complex rules, but also aim to eliminate behavioural biases.
Lets remind ourselves of the requirements for a working investment process and how the Lapis fund fits the criteria:
... investment strategies THAT WORK tend to be low fee, diversified, low turnover AND taking into account behavioural biases.
Low fee: the fund charges an annual management fee of 0.45%, with an additional cost of 0.3%, for a total of 0.75%. While a lot of ETFs are still cheaper, as an actively managed fund, the Lapis fund falls into the lower cost funds and therefore fulfills criterium number one.
Diversified: The Lapis fund invests globally and includes companies from the US, Japan, Switzerland, UK and EU.
It also represents companies from various different sectors of the industry, such as Oil, Pharma, Insurance, Banking, Consumer Staples, Telecoms, etc
It therefore can be classed as well diversified (but not over-diversified, a topic for one of the next blogs).
Low turnover: Based on the three inclusion criteria (Div.yield, mkt.cap, CAGR of div) there are few changes every quarter. Over the last two years, quarterly changes were one or two companies per quarter. The quarterly rebalancing to 4% weighting g in the fund for each company leads to some "activity" with regards to turnover, but is easily offset by the gains made from the inherent system of "buy low - sell high", as stocks that have advanced during the quarter get pared back to 4% weight (taking profits = selling high), while those that have lagged will be added to (buying low).
Behavioural biases: The application of the funds rules is strict, which means that after the criteria and rules are set based on human research, there is no further human pondering necessary and therefore it is not prone to any behavioural biases!
Again, this is just one example, but one that works and shows that simple rules based investing can beat both the general market as well as funds where the fund manager is prone to behavioural fallacies.
As an investor you are therefore well advised to either scour the market for rules based funds and ETFs or set your own set of rules AND Stay the Course! In the long run, this will lead to superior returns as well as let you sleep well at night.