Is there any accuracy in history?

Is there any accuracy in history? Can you safely drive forward while only looking into your rear-view mirror?

‍

‍

There is a reason why your windshield is bigger than your rear-view mirror. Because where you’re going is much more important than where you’ve come from.

‍

We recently held our annual client event in Sydney, in the beautiful boardroom at The Langham Hotel. For those of you who attended the evening – you will remember my opening remark to the room was ‘apparently history repeats itself, in my view when it comes down to financial markets, this is far from the truth. While important lessons can be learned, markets are not mechanical. Instead, they are largely driven by emotion and behaviour’.

‍

Coincidentally a few weeks after our client event Howard Marks, one of the most renowned investors of all time sent around his latest memo. Howard’s opening quote was:

‍

‘History doesn’t repeat itself, but it does rhyme. The events of investment history don’t repeat, but familiar themes do recur, especially behavioural themes.’ (Howard was quoting Mark Twain.)

‍

I am in no way comparing myself to this great legend of financial markets. However, our coincidental thinking highlights not even global banks with the largest of budgets, or fund managers employing the smartest of minds, or economists with multiple degrees can possibly predict short-term financial market movements. Both the heads of our Reserve Bank and the US Fed Reserve had their economic forecasts completely wrong regarding inflation expectations.

‍

Investing is purely an emotional game. It’s often said financial markets are driven ‘90% by emotion and 10% by fundamentals’. For today’s note you can breathe a sigh of relief. I won’t rattle off inflation, economic figures and reams of data. These figures are changing daily. Few predictions are ever correct. Does all this data really matter over the long term? In my opinion, no.

‍

Inflation. Stagflation. Energy prices. Decarbonisation. Higher interest rates. Supply chain issues. Shrinking economic growth in the US. Shrinking global growth. Falling company profits. Collapsing asset values. A US recession. An Australian recession. A global recession. Putin. Xi Xinping. A War! And the list goes on…….

‍

And for the good news? The world doesn’t end. Markets can and will recover. Way beyond where these markets have tumbled from. Central Banks and Governments WILL engineer the future recovery. The key will be having your capital deployed during this recovery. It can’t be an afterthought.

‍

In my view, the listed share market always tries to look over the valley of bad news, doomsday economic forecasts to look for positive light at the end of the tunnel. Listed markets recover well before the economic recovery. Unfortunately, it’s the larger illiquid asset markets, including privately owned businesses and the property market which are about to see a very similar downward correction. Australia’s housing market – we’re currently seeing Sydney housing prices contract much faster than the GFC, at an even faster rate than the great depression of 1932. Three of Australia’s major banks now forecast the national property market to fall 20% or more by end of 2023. Several economists predicting much greater falls than this. (Source abc.net.au, 7/6/22, https://www.macrobusiness.com.au/2022/06/aussie-housing-market-braces-for-3-trillion-wipeout/)

‍

A recent aggressive valuation write-down in privately held businesses is Australia’s latest tech unicorn Canva. Valued at more than $55billion during September last year, Franklin Templeton reduced their book valuation of Canva by one-third in one day. Franklin then reduced the valuation of Canva a further 30% a few weeks ago. Although privately owned, Canva’s value is now two-thirds lower than it was just 9 months ago. (Source: smh.com.au, ‘Technology australian-tech-investors-mega-bet-on-unicorn-canva-is-about-to-be-tested’.)

‍

Fact is bear markets are more common than leap years and almost as common as Christmas. The average investor will live through 22 bear markets in their lifetime. (A bear market is when a market falls greater than 20% from it’s high).

‍

Ironically investors quickly disregarded the most recent ‘bear market’ during 2020. This bear market lasted less than 3 months. During the pandemic, the global share market fell more than 40%. Then quickly recovered and in some cases, rose by approximately 100%. By the end of 2020 the global share market enjoyed a return of more than 18% (Global MSCI). During a ‘bear market’.

‍

We clearly remember the sheer level of investor panic during the pandemic. Our role became emotional coaches, counselling clients into not selling, to focus on staying the course. A more difficult role was convincing new clients to commit as many funds as possible during the market low. In my view we’re seeing a very similar market cycle once again, given the sheer level of pessimism around the world currently. Controlling anxiety and fear is much easier said than done though.  

‍

Today I’ll relay a very important story. Unfortunately, during the pandemic, we had one client who could not stand the bad news around the world or continue to see his portfolio fall any further. This client instructed us to sell his entire portfolio. He could not be convinced otherwise. This story is particularly important as it illustrates how critical it is to remain invested. Missing out on the recovery – which will happen, can potentially reverse decades of retirement savings.

‍

For privacy reasons I will refer to this client as ‘Bob’. For illustration I will say Bob’s portfolio was worth $1M during early February 2020. Bob instructed us to sell his entire portfolio (to cash) on 20 March 2020. Bob realised a little over $634,000. Had Bob have done nothing and instead held his portfolio, Bob’s current portfolio would now be more than $1,167,000. This value incudes the recent stock market correction of more than 22% (S&P500). (These figures do not include potential tax implications realised by Bob, the eroding value of inflation or other costs).

‍

Bob’s example really proves the importance of not panicking and most importantly, remaining invested during the recovery. The timing of which no one can predict. Long term wealth is generated by those investors who have the nerve to hold their ground. Not be influenced by the raft of short-term media noise and panic. So, leading to today’s topic – ‘Behavioural Finance’, which is very timely topic given the turbulence within the global economy. Particularly when frightening words like ‘bear market’, ‘crash’ and ‘recession’ are being constantly being thrown around by the media.

‍

I was first exposed to ‘Behavioural Finance Theory’ during my time at UBS around 12 years ago. UBS employed a team of behavioural scientists who travelled around the Globe, educating both advisors and clients on how to become more successful at investing. These sessions were fascinating and uplifting, as the content really made sense as to how and why investing isn’t as easy as you’d believe.

‍

Behavioural finance is the study of how psychology impacts the decision-making process of investors. In an ideal world people will always make optimal (or rational) decisions. A ‘rational person’ has complete self-control, is completely unmoved by their emotions or external factors. As we’re aware – humans aren’t rational or capable of making great decisions all the time!  

‍

A simple example is the challenge to get healthier or lose weight. Mathematically it’s the simple calculation of total energy in less energy out. Resisting that dessert at a restaurant or rolling over to smash that alarm clock for the early gym class. We’ve all been there. The reason why gym memberships see their highest numbers during the New Year. It’s these personal biases and social influences which impact us all. The very same emotional biases also take control of investment decision making.

‍

This fascinating topic originated during the early 1980’s, pioneered by Kahneman and Tversky (K&T), who later began educating the broader investing population about classic ‘financial blind spots’.

‍

With limited time, today I’ve instead focussed on the main counterproductive biases which are influencing us all when it comes to financial decision making. I’d urge you to study more of these topics in your own time – valuable self-improvement!

‍

‍

The real costs of irrational behaviour

‍

Investors naturally have very limited self-control when investing, which results in significant real economic costs. K&T went on to prove what investors should be earning vs what the average investor did earn investing in the US stock market. K&T’s survey shocked the investment world.

‍

DALBAR published their results, collating the data for all US mutual fund sales/purchases over a 20-year period to from 1999 to 2019. K&T proved the average ‘DIY investor’ (those control their own portfolio and made their own decisions) returned 4.25% pa. Over the very same 20-year period the US stock market returned 10.86% pa (ignoring transaction costs, taxation, and inflation). Due to the success of this initial survey, DALBAR continue to update and publish these results annually.

‍

Adjusting these returns for inflation, the market returned more than seven times that of the average DIY investor each year. (Source: DALBAR Inc.)

‍

‍

Anchoring Bias

‍

An example of anchoring is when an investor expects an annual return, based upon previous experiences. For example, if the market delivers 20% pa in over several years in succession, this return becomes the expected norm. Another example is when an investor refers to their portfolio at its extreme highest valuation as the benchmark, which becomes the hurdle for the investment.

‍

‍

Loss aversion

‍

Also referred to as the ‘disposition effect’, arguably the most important bias. The fact is investors dislike incurring losses four times more than making capital gains.

‍

The sole reason why DIY investors regularly adopt the strategy of selling winning investments too early, buying into the assets that had the best return in the previous year, or continuing to hold poor quality investments because of a short period of high performance that become loss making. Stroking our own ego makes us feel great. We’re human!

‍

Professional investors or fund managers on the other hand adopt the reverse approach to this strategy, as they are familiar with these emotional biases and can extract these during the investment decision process much more effectively. They focus on the facts – the fundamentals of companies, how well they are operating and only use the share price to gauge value relative to this. They take profit off the table when valuations become excessive and add to assets the underperformed in a different stage of the cycle (which are now attractively valued).

‍

‍

Herd Behaviour

‍

We’re naturally comforted by following the crowd. It’s how we’re all wired. If you’re looking for a great restaurant to dine in – we won’t step into an empty restaurant. We instead subconsciously search for the restaurant full of people. Although there’s no proof the food is any better and the service could take longer.

‍

Herd mentality is even more prevalent during financial market booms and busts. Herd behaviour feeds upon itself. It’s the reason why markets become consumed in both speculative buying frenzies as well stock market crashes. Greed vs. despair. Its why investors are commonly referred to as lemmings jumping off a cliff.

‍

‍

Experiential/recency bias

‍

This arises when investors believe an event is far more likely to occur than possible. During a simple coin-tossing game, if heads turn up five times in succession, more than 70% of people bet tails is next. Although the odds remain at 50%.

‍

Similarly, when investors live through multiple share market corrections. Investors become so emotionally impacted they’re unable to see a positive future. Ever.

‍

‍

Familiarity bias

‍

Familiarity bias is when investors are attracted to those investments they know the best, such as investing only in ASX shares. Many property investors are guilty of this same bias. Buying an investment property not only in their own city or suburb, but in some cases in their very own street.

‍

Equally when an investor buys a holiday home in the town, they’ve recently holidayed in. Since that town delivered great memories with family and friends, emotionally influencing their decision. Emotional financial decisions such as these result in much lower returns with much greater concentration risk.

‍

Market crashes cause stress and panic. When we’re under stress or panic, our brains release a hormone called ‘catecholamines’. This chemical raises our heart rate, makes us lose sleep and causes mental health issues.  It’s the very same chemical which made caveman run from wild animals. Understanding how our little brains are wired and why we’re unable to think and act rationally when making investment decisions is critical.

‍

Fact is volatility is a natural function of a healthy investment market. Risk cannot exist without volatility. Return cannot exist without risk. Market corrections are not a punishment – they are the fee charged for successful long-term investors.

‍

Investing is simply putting faith in the future. It’s this constant battle between fear of the short-term unknown and the certainty of the future. If you have a long-term strategy, receive sound financial advice. Human emotion is the single largest determinant of your returns. Controlling your emotions to understand this battle is the most important decision an investor can ever make.

‍

As Warren Buffett famously said: ‘Public opinion poll is not substitute for fact’.

‍

The fact is that markets will be materially higher than where they stand today. Think and act contrarily.

‍

Until next time,  Craig

‍

‍