Behaviourism and the investor

Over the past few decades, many experts in the field of behavioural finance argue the complex and highly emotional process of staking our financial future on a portfolio of companies triggers the reflexive system of the human brain.

In short, this process subsequently prompts investors to take irrational decisions, including panic buying and selling shares, overtrading, refusing to budge on preconceived ideas and blindly following whatever we’re told to believe.

This worrying conclusion hasn’t been lost on the big name investors of past and present generations. The likes of Warren Buffett, founder of Berkshire Hathaway, are known for devising various unconventional strategies in a bid to detach themselves from the emotional rollercoaster of equity investing.

But while keeping one’s emotions in check sounds like a fairly simple task, countless stories of people continually getting burnt by giving into them indicates few in the game have been sufficiently able to master what the experts frequently refer to as the basic rules of investing.

Rule 1: Don’t fall in love
One way to avoid emotional bias is to not fall in love with any particular investment. Be objective and focus on the numbers, not the back story.

For Steve Davies, manager of four Jupiter growth funds and investment trusts, one of the most obvious pitfalls is falling excessively in love with a company after a period of successful returns.

“The warm feelings you have towards the company and the people running it are hard to overcome, and it’s always easy to find reasons not to sell and move on,” he warns.

To combat the risk of holding onto stocks for too long, and identify new opportunities, many managers and brokers formulate ‘target prices’ at which they will sell or top-slice holdings.

This practice enables managers to ascertain whether the equities he monitors are fairly valued and how much further they can realistically fall or rise.

For example, target prices can be calculated by looking at profit and cash flow forecasts over a two-year period. Stretching any further, according to Mr Davies, would be “detrimental to accuracy”, while focusing on a shorter period risks failing to factor in the time it takes for a troubled company to stabilise its operations and bounce back.

It is also useful to focus on cash profits rather than accounting profits, as the latter can be more subjective and easier to manipulate.

Lloyds Bank
Jupiter’s Steve Davies’ model indicates Lloyds Bank can deliver sustainable earnings of around 8p a share, and that it can return around 6p per share in the form of dividends or buybacks.

The FTSE All-Share Index has an overall dividend yield of 4.19 per cent, but it may take a while for bank dividends to be valued as highly as this.

Mr Davies therefore uses a 5 per cent yield to derive a target price for Lloyds of 120p. That represents potential upside to the current share price.

Factoring in high levels of conviction and the fact Lloyds is a highly liquid stock, this is why it is the largest holding in the portfolio currently (as at 30 June 2016).

Rule 2: Don’t buy flavour of the month
Jason Hollands, managing director at Tilney Bestinvest, thinks being systematic is important when it comes to investing. He says: “I think it’s important to try and curtail your emotions and to run with a set of disciplines to keep these in check.

“It’s all too easy to anchor around an investment that has clearly not worked out and hold on too long because no one likes to admit they made a mistake, or to get swept up in the excitement around investments or asset classes that have enjoyed a recent strong run or are being hyped.

“That often results in self-directed investors developing a very long tail on their portfolios, with too many legacy holdings as they retain yesterday’s ideas and continually add whatever is flavour of the moment.”

To counteract this kind of behavior, Mr Hollands first advises capping the number of funds someone holds in their portfolio 20, regardless of how much money is invested.

He claims holding any more could hinder the ability of investors to reassess their convictions, which is something he describes as a “vital discipline”.

By rebalancing a portfolio twice a year, he reckons investors are more likely to take profits before share prices run out of steam, and correctly redeploy these funds into new investments that match an individual’s long-term goals and risk profile.

Rule 3: Don’t be dogmatic
Not everyone with successful track records is known for instilling rigid discipline into their investment processes.

Whereas some favour sticking to tried-and-tested formulas, others such as fund manager James Henderson prefer to adapt depending on the circumstances. Therefore, being flexible is a good trait to have as an investor.

“There are no particular disciplines that will work. Things keep changing, patterns change, so you can’t be dogmatic,” he says.

As a value investor with a goal of buying troubled, underappreciated companies on the brink of recovery, Mr Henderson’s main philosophy is built around acquiring shares in equities with low price-to-earnings ratios.

Like many of his peers, he aims to buy low and sell high, a strategy that also requires stomaching a little pain along the way.

That includes unfortunate moments when a company warns on profits. Such scenarios often trigger widespread panic and sell-offs among the masses, while simultaneously opening up opportunities for bullish observers to purchase stocks at big discounts.

Many in the investment world contend cheap shares, particularly the widely researched blue-chip ones, are inexpensive for a reason.

Yet value investors such as Mr Henderson assert the market often fails to price in the recovery potential of struggling companies, particularly as plenty sold their stakes at a loss without thinking rationally about the longer-term potential.

After numerous years in the game, the manager of four funds, including Lowland Investment Company and Henderson UK Equity Income & Growth, has developed a penchant for identifying companies showing early signs of a turnaround.

Sometimes these much needed operational changes, described by Mr Henderson as periods of self-discovery, occur when a new management team is installed.

Rule 4: Learn from your mistakes
One of Mr Henderson’s biggest success stories came from a hunch the appointment of Mike Humphrey as chief executive of Croda in 1999 would bring the maker of surfactants, which are used in ingredients for cosmetic creams, lotions and dietary supplements, back to the top.

His faith in the specialty chemical firm’s back to basics strategy turned out to well founded – the shares rose sharply from roughly £2 to £22 during Mr Humphrey’s 13-year tenure.

But Mr Henderson spent more time dwelling over his decision to cap his holding at 2 per cent. This ended up being one of his big regrets, and a catalyst for him loosening his conservative approach in later years when buying a stake in Senior.

Unfortunately for him and his clients, the depressed oil price and truck market have since weighed on the aerospace, military and vehicle components manufacturer’s shares.

“You must be careful what you learn from each mistake,” he concludes. “There isn’t a right way of doing it. Every investment approach has its moments. What doesn’t work is moving between approaches too fast.

“You can modify your approach, but don’t abandon it completely. This is because over time growth, value and contrarian investment works. What doesn’t is following what is in favour and abandoning it when it does wrong. Buying yesterday’s stories is not the way to go.

“If you keep that discipline of buying on weakness and selling on strength, you should be fine over the long-term. My strategy for now is to buy slower on weakness and reduce slower on strength. In the past I’ve always been too early, so this time I want to do things more gradually.”

Rule 5: Avoid the crowd
Chartered financial planner Philip Milton reckons growing communication methods across the world are creating potentially better opportunities to find unloved winners.

With many newspaper columns and internet forums dedicated to endorsing the prospects of the next big trend, the likes of Mr Milton take advantage by focusing on companies specialising in dull things that people seldom talk about.

Following the crowd is often recognised as one of the biggest flaws in investment circles. Many feel safe when following recommendations, even though history has repeatedly shown these uninformed decisions seldom achieve the desired result.

From Sir Isaac Newton’s costly mistake of backing the South Sea Bubble in 1720, through to the recent dramatic downfall of the seemingly profitable insurance technology group Quindell to investors have been punished for blindly following the latest hype.

Rule 6: Don’t think you can’t lose
Mr Milton points to the residential property market craze as a classic example of another big behavioural weakness in investors – overconfidence. “The residential property market… demonstrates all the worst traits of behavioural bias,” he says.

“People don’t think they can ever lose, that significant annual out-performance of this inanimate object over inflation, earnings and anything else are assured ad infinitum, and that there is no risk in borrowing to invest (or to buy one’s home).

“Then they assume that even if things began to be tricky they could simply ride-out the minimal upset till the next doubling in seven years. Or they would sell, oblivious to the fact that ‘everybody else’ would be looking to do the same thing.

“They have no concept that interest rates can rise and exceed the rentals from their buy-to-lets, that tenants can cause them grief and leave them nursing several thousands of pounds of repair and redecoration costs upon vacation, and that structural works need to be undertaken from time to time.”

As a financial adviser, Mr Milton concludes that it’s important to educate clients about these types of unfavourable habits in a bid to steer them away from following a similarly painful path to financial ruin.

Rule 7: Don’t obsess daily
Not all investors – or their advisers - think long-term and investors’ fears can be exacerbated by overly checking and re-checking performance of markets and funds.

Dave Penny, managing director of Invest Southwest, says he has numerous stories of financial advisers obsessively checking the value of the FTSE index at regular intervals on the golf course.

This particular characteristic has become a major talking point for behavioural finance academics, many of which argue the monitoring of constant price changes is often a trigger for irrational emotional responses.

Plenty of the industry’s greats agree with this line of thinking. Whereas Warren Buffett is known for having no Bloomberg terminal on his desk, Walter Schloss avoided computers altogether, choosing instead to monitor price quotes in newspapers.

Meanwhile, David Einhorn’s prefers to take time out after the sudden arrival of bad news, mainly because he isn’t able to think rationally in the immediate aftermath of a bombshell.

Rule 8: Nothing is a ‘dead cert’
Another flaw Mr Penny occasionally notices is that of placing clients with different attitudes to risk into the same investment plan, simply because it has been a good performer in the past.

A couple of years ago he recalls one adviser telling him he put all his clients in corporate bonds “because he knew they would do well in the future”. In another case, he remembers meeting a client who was advised by her previous adviser to invest in two property funds.

She eventually saw the value of her portfolio halve, despite initially being reassured her investment was safe and diverse.

Those familiar with the stock market will know that certainties don’t exist, particularly as the statistics and forecasts used by the majority of investors have regularly come up short in the past.

Corroborating this theory was research compiled by IMF economist Prakash Loungani in 2000. By looking at GDP forecasts around the world between 1989 and 1999, Mr Loungani found of the 60 recessions that occurred in this period, economists had failed to foresee 58 of them. The financial recession of 2008, too, can be added to this list.

Stay dull, diversified and long-term
Given the uncertainty surrounding global economies and equity markets, many view diversification as a fundamental tool to protect investors from volatility.

Mr Penny, who describes his style as “extremely dull”, uses asset allocation models to provide clients with a suitable number of viable options.

But while he swears by this policy of using pre-packaged models, he’s also aware of the pitfalls of sticking with an investment strategy based on positive past performances.

As a result, he attempts to blend this formula with a tactical approach that’s adaptable depending on market environments.

“We work hard to segment clients’ funds, risk profile that which is appropriate for a fluctuating investment, and then buy in expensive asset allocation models which blend strategic and tactical approaches,” he says.

“I have often thought that they are wrong on property, cash and bonds, and even occasionally argued about it. But we subscribe to this process and we stick with it.

“In good times and conversely poor equity markets we have been delighted with the returns and the ability of our clients to understand the various levels of performance within the portfolio.”

Daniel Liberto is a former companies writer at Investors Chronicle