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Archive: Oct 2015

  1. Unhealthy Attachments

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    Have you ever made yourself suffer through a bad movie because, having paid for the cinema ticket, you felt you had to get your money’s worth? Some people treat investment the same way.

    Behavioural economists have a name for this tendency of people and organisations to stick with a losing strategy purely on the basis that they have put so much time and money into it already. It’s called the “sunk cost fallacy”.

    Let’s say a couple buy a property next to a freeway, believing that planting trees and double-glazing will block out the noise. Thousands of dollars later the place is still unliveable, but they won’t sell because “that would be a waste of money”.

    This is an example of a sunk cost. Despite the strong likelihood that you’ll never get your money back, regardless of outcomes, you are reluctant to cut your losses and sell because that would involve an admission of defeat.

    It works like this in the equity market too. People will often speculate on a particular stock on the basis of newspaper articles about prospects for the company or industry. When those forecasts don’t come to pass, they hold on regardless.

    It might be a mining stock that is hyped based on bullish projections for a new tenement. Later, when it becomes clear the prospect is not what its promoters claimed, some investors will still hold on, based on the erroneous view that they can make their money back.

    The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don’t want to believe our efforts have been in vain. But there are ways of dealing with this challenge. Here are seven simple rules:

    • Accept that not every investment will be a winner. Stocks rise and fall based on news and on the markets’ collective view of their prospects. That there is risk around outcomes is why there is the prospect of a return.
    • While risk and return are related, not every risk is worth taking. Taking big bets on individual stocks or industries leaves you open to idiosyncratic influences like changing technology. Think about what happened to Kodak.
    • Diversification can help wash away these individual influences. Over time, we know there is a capital market rate of return. But it is not divided equally among stocks or uniformly across time. So spread your risk.
    • Understand how markets work. If you hear on the news about the great prospects for a particular company or sector, the chances are the market already knows that and has priced the security accordingly.
    • Look to the future, not to the past. The financial news is interesting, but it is about what has already happened and there is nothing much you can do about that. Investment is about what happens next.
    • Don’t fall in love with your investments. People often go wrong by sinking emotional capital into a losing stock that they just can’t let go. It’s easier to maintain discipline if you maintain a little distance from your portfolio.
    • Rebalance regularly. This is another way of staying disciplined. If the equity part of your portfolio has risen in value, you might sell down the winners and put the money into bonds to maintain your desired allocation.

    These are simple rules. But they are all practical ways of taking your ego out of the investment process and avoiding the sunk cost fallacy.

    There is no single perfect portfolio, by the way. There are in fact an infinite number of possibilities, but based on the needs and risk profile of each individual, not on “hot tips” or the views of high-profile financial commentators.

    This approach may not be as interesting. But by keeping an emotional distance between yourself and your portfolio, you can avoid some unhealthy attachments.

     

  2. The Patient Principal

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    Global markets are providing investors a rough ride at the moment, as the focus turns to China’s economic outlook. But while falling markets can be worrisome, maintaining a longer-term perspective makes the volatility easier to handle.

    A typical response to unsettling markets is an emotional one. We quit risky assets when prices are down and wait for more “certainty”.

    These timing strategies can take a few forms. One is to use forecasting to get out when the market is judged as “over-bought” and then to buy back in when the signals tell you it is “over-sold”.

    A second strategy might be to undertake a comprehensive macro-economic analysis of the Chinese economy, its monetary policy, global trade and investment linkages and how the various scenarios around these issues might play out in global markets.

    In the first instance, there is very little evidence that these forecast-based timing decisions work with any consistency. And even if people manage to luck their way out of the market at the right time, they still have to decide when to get back in.

    In the second instance, you can be the world’s best economist and make an accurate assessment of the growth trajectory of China, together with the policy response. But that still doesn’t mean the markets will react as you assume.

    A third way is to reflect on how markets price risk. Over the long term, we know there is a return on capital. But those returns are rarely delivered in an even pattern. There are periods when markets fall precipitously and others where they rise inexorably.

    The only way of getting that “average” return is to go with the flow. Think about it this way. A sign at the river’s edge reads: “Average depth: three feet”. Reading the sign, the hiker thinks: “OK, I can wade across”. But he soon discovers the “average” masks a range of everything from 6 inches to 15 feet.

    Likewise, financial products are frequently advertised as offering “average” returns of, say, 8%, without the promoters acknowledging in a prominent way that individual year returns can be many multiples of that average in either direction.

    Now there may be nothing wrong with that sort of volatility if the individual can stomach it. But others can feel uncomfortable. And that’s OK too. The important point is being prepared about possible outcomes from your investment choices.

    Markets rarely move in one direction for long. If they did, there would be little risk in investing. And in the absence of risk, there would be no return. One element of risk, although not the whole story, is the volatility of an investment.

    Look at a world share market benchmark such as the MSCI World Index, in US dollars. In the 45 years from 1970 to 2014, the index has registered annual gains of as high as 41.9% (in 1986) and losses of as much as 40.7% (2008).

    But over that full period, the index delivered an annualised rate of return of 8.9%. To earn that return, you had to remain fully invested, taking the unsettling down periods with the heartening up markets, but also rebalancing each year to return your desired asset allocation back to where you want it to be.

    Timing your exit and entry successfully is a tough ask. Look at 2008, the year of the global financial crisis and the worst single year in our sample. Yet, the MSCI World index in the following year registered one of its best-ever gains.

    Now, none of this is to imply that the market is due for a rebound anytime soon. It might. It might not. The fact is no-one can be sure. But we do know that whenever there is a great deal of uncertainty, there will be a great deal of volatility.

    Second-guessing markets means second-guessing news. What has happened is already priced in. What happens next is what we don’t know, so we diversify and spread our risk to match our own appetite and expectations.

    Spreading risk can mean diversifying within equities across different stocks, sectors, industries and countries. It also means diversifying across asset classes. For instance, while shares have been performing poorly, bonds have been doing well.

    Markets are constantly adjusting to news. A fall in prices means investors are collectively demanding an additional return for the risk of owning equities. But for the individual investor, the price decline only matters if they need the money today.

    If your horizon is five, 10, 15 or 20 years, the uncertainty will soon fade and the markets will go onto worrying about something else. Ultimately what drives your return is how you allocate your capital across different assets, how much you invest over time and the power of compounding.

    But in the short-term, the greatest contribution you can make to your long-term wealth is exercising patience. And that’s where your adviser comes in.