Bob Van Munster examines investors’ tendency to only see what they want to see
Long periods of market volatility and uncertainty are sure to inject fear into investors. The recent global financial crisis is a prime example. During such periods, there tends to be a rise in the number of unopened superannuation statements in Australian households, with investors fearful of seeing how much the value of their retirement nest egg has fallen. How many unopened envelopes are sitting in people’s bottom drawers right now? Why do we behave that way?
In our previous articles in Professional Planner, we have looked at a range of investor behaviours – such as representativeness, fear of regret, and frame dependence – and highlighted how they influence investors’ decisions. In this article, drawing on the work by Martin L Leibowitz, we look at some more behaviours and the impact they can have on markets. Specifically we cover: the ebullience cycle (“unopened envelope” syndrome, mentioned above); confirmation bias (where investors seek other “like” opinions to reaffirm their own views); and price-target revisionism (where a target price is reached and then revised upwards). Having an understanding of how people react in different market conditions can provide a valuable insight into why your clients may not respond to an investment proposal or advice as well as you would like. It may also provide some insight into why markets behave the way they do and the potential for contrarian strategies.
UNDERSTANDING MARKET INEFFICIENCY
Before delving into the behaviours, I’d like first to touch on the concept of market inefficiency. Firstly, let me clarify upfront that Tyndall is an active manager. Contrary to the efficient market hypothesis, our Australian equities and fixed interest teams believe that markets are not always efficient, with various factors causing securities to be temporarily mispriced, providing opportunities for active managers to add value. There are two broad types of market inefficiency: acute and chronic. Acute inefficiencies tend to be short and sharp and can be exploited through arbitrage trades; chronic inefficiencies tend to last for longer periods of time and can be harder to identify. As the renowned English economist, John Maynard Keynes, remarked: “The market can stay irrational longer than you can remain solvent.”
Fund managers tend to focus on the chronic inefficiencies in the market, because they are longer-term in nature, and also because not many mandates permit managers to take advantage of acute inefficiencies. As chronic inefficiencies can be ambiguous and harder to identify, intensive research is required to discover and take advantage of them – which is what the teams of analysts at funds management companies are experts at. Chronic inefficiencies can arise due to structural reasons (such as trading frictions, organisational barriers, imbalances in capital flows and valuation ambiguities) as well as behavioural reasons (such as the ones we’ve covered in previous articles, along with others such as herding, compulsive confirmation seeking, inertia, overly rigid policy portfolios and artificial peer comparisons).
Also referred to as the “unopened envelope” syndrome, this behaviour is particularly relevant, given recent market movements. During the financial crisis, superannuation fund performance took a beating. While the markets have since calmed and returns are edging back into positive territory, the period was no doubt a difficult time for investors, particularly after they experienced so many years of positive growth leading up to the crisis. During such poor-performing periods, it’s quite a confronting moment when the annual investment statement arrives in the post. Investors face the dilemma, “to open or not to open?”.
The “fear” emotion quickly takes hold, paralysing investors. If they open the statement, it might confirm their worst fears that the value of their retirement savings has plummeted. Not opening it is much easier – best to just forget about it and file it away for another day. That way, they need never acknowledge the potential damage. Such behaviour is understandable (to a degree); and in some respects, given that superannuation is a long-term investment for many investors, it’s a healthy practice not to focus too heavily on short-term performance. However, by not opening the statement there is a danger that investors may not be aware that they are in the wrong fund for their particular lifecycle stage (that is, they are just starting out in their career and are invested in a conservative fund), they are paying excessive fees, are invested in a poor-performing fund relative to other similar products in the market or need to rebalance their portfolio.
Conversely, during good times, investors are quite excited to open the statement and see how much their investment has grown in value over the course of the year. They are so thrilled with what they see and with their investment expertise that they are tempted to invest more in the particular fund (or stock). The danger here is that investors could end up taking on more risk than they realise. Opening the statement is the ideal time to do a health check on the fund or investment, review other options and possibly switch into a more suitable fund. Remaining in a state of denial and doing nothing can sometimes be a worse decision than actually making a conscious decision to make a change.
Confirmation bias is classic investor behaviour. It occurs when investors seek opinions from others; but instead of looking for a variety of opinions, they tend to gravitate to those who they know share their views, in order to provide confirmation that they are right. For example, investors might call a particular broker, or read commentaries from market commentators who tend to think like they do. Even if investors are provided with contradictory information, they can remain so steadfast in their opinions that they discount the alternative view as incorrect when making their investment decisions. We saw this behaviour play out in the healthcare sector recently.
The Federal Government has flagged on many occasions that there were impending changes to the sector, but many investors ignored the signals, only to be highly surprised when companies released their profit results during the February 2010 reporting season. Confirmation bias is a dangerous behaviour and ultimately the investor can pay the price. By not taking into consideration different views, investors can make misguided decisions – and they are likely to be financially hurt by the outcome when the share price fails to perform as they expect or there is a surprise announcement. To reduce this behavioural bias, investors should actively seek out and consider views contrary to their own, so that they can gain a better feel for the true value and potential of a company – and ultimately make more informed decisions.
This is an interesting behaviour and a trap that many investors, individuals and professionals alike, can fall into. Price-target revisionism occurs when investors set price targets for their investments, but as that target approaches, they feel vindicated and so confident in their original investment decision that they revise the target further upwards. This behaviour is a classic symptom of “greed” – whereby rational thinking takes a back seat to the desire for ever higher returns. While it can be hard to resist the urge to revise a target price when the markets are moving higher, holding on to an investment can backfire in the long run. The price of the security can fall quickly and sharply to below the original target price (or even below the purchase price) and the investor can end up worse off.
One method suggested by Leibowitz to help reduce this risk is for the investor to sell off portions of their holding as the target price approaches – that way, they lock in gains along the way. The investor might also be wise, before entering into the investment, to set up a “plan of attack” that sets out steps in advance of what to do if the price rises or falls to certain levels. Having a plan in advance helps remove the emotive element at the outset. Professional investors, such as fund managers, follow a similar process in many respects. At Tyndall, for example, we set price targets (or “fair values”) for each share in our universe based on our analysts’ extensive research. When the stock reaches the target, we begin the process of selling down our holding. Similarly, if the price moves against us, we have agreed prices in place where we will liquidate the position and, if need be, realise losses.
Forgoing the potential for further gains or realising a loss can be a difficult task, even for the most hardened and experienced portfolio managers; but having a process in place (and an investment committee overseeing the process) reduces the emotive element and helps the portfolio managers maintain their focus. There have been occasions when we have exited a stock once the price target was reached only to watch the stock march higher; but then, often, there are times when we have been proven correct, with the stock proceeding to plummet quickly and sharply. A good example of this was our investment in Bradken, a global manufacturer and supplier of parts to the mining, rail and power industries.
In our flagship Australian equity fund, the Tyndall Australian Share Wholesale Portfolio, we gradually bought into Bradken between March 2005 and August 2005 at an average price of around $2.45. We then sold it between December 2006 and January 2007 at an average price of around $8 following a sharp rally. We believed $8 was the fair value for the stock and hence decided it was time to sell our holding. We had made a very healthy gain on that investment and simply couldn’t justify holding onto it any longer. To hold onto it beyond that price was contrary to our investment process and represented too much risk. The stock did continue to rally to a high of around $15 in December 2007, but we were vindicated by our decision to sell, with the stock subsequently falling sharply to around $6 just one month later – a much lower price than our sale price (see chart 1).
The stock staged a short rally in 2008, but then fell away again back to around $1 in March 2009 – below the starting price of our investment. Of course we would have been very happy to sell the stock at $15; but investors who didn’t have an unemotional process in place to sell at $8 may well have still been holding it at $1 in March 2009. And if they panicked with the rest of the market and decided to sell, they would have realised a significant loss, after holding the stock for several years. It’s not easy to watch a stock keep running after you’ve sold it, but it’s important to keep your nerve, stick by your guns and not be swayed by the “market noise”. Sure, you might miss out on some upside in the short term, but it’s a lower-risk strategy than holding on and suffering the downside.
There are many investor behaviours which are often difficult to identify and control. As this article shows, sticking your head in the sand during the tough times, making over-zealous decisions during the good times, having a “one-eyed” view and not following set price targets are just a few of the classic investor behaviours that can lead not only to bad investment decisions, but poor investment outcomes. These behaviours can be widespread, particularly during periods of market extremes, which can in turn serve to create market inefficiencies. Being aware of these behaviours and having an understanding of their impact on markets can not only help make investors more informed, but it can also help identify investment opportunities for the savvy investor. At the end of the day though, seeking assistance from a financial adviser and investing with a professional fund manager are perhaps the wisest steps investors can take to try and reduce these behavioural biases and ultimately achieve a better investment outcome.