Praemium

Investor PsychologySMSF Strategies

The tortoise beats the hare in the investment game

3 Dec 2021 5 month(s) ago

Taking your time over investment decisions tends to get better results.

In share investment, slow, thoughtful trading tends to beat fast, rapid response trading. When markets suddenly change, the natural psychological response is to react as quickly as possible. If prices are falling, investors will tend to rush to the door as quickly as they can; if prices are rising they will want to buy before prices go even higher. It is the chief symptom of the bandwagon bias: the tendency for investors to move in herds.

It does not work. Looking at returns over 20 years in the US market the capital markets returned about 8 % but the average investor in America got only 5 %. Why? Investors bought when the market went up because a broker told them to, and they sold when the market went down and they panicked. The bandwagon is not a good place to be in investment.

The key is the speed of response. A much better option is what is known as slow trading. Careful and systematic traders will often hang on to a stock for a long time. Stocks that are falling tend to continue to fall, and stocks that are rising go on rising. As one fund manager says, this was why the legendary economist John Maynard Keynes did so well:

“The secret to Keynes’s eventual profits is that he changed his approach. He abandoned macroeconomic forecasting entirely. Instead, he sought out well-managed companies with strong dividend yields, and held on to them for the long term. This approach is now associated with Warren Buffett, who quotes Keynes’s investment maxims with approval. But the key insight is that the strategy does not require macroeconomic predictions. Keynes, the most influential macroeconomist in history, realised not only that such forecasts were beyond his skill but that they were unnecessary.”

Here are the returns on asset classes from 1985 to 2020 (starting point $1; world equities $35, short term world government bonds $17):

Research studies on momentum indicate that when a price is falling then, on the balance of probability, it is likely to continue to fall. Investors should not ‘catch a falling sword’. Conversely, when the price is going up, it is likely to continue to go up. So there are strategies that have been developed around the harnessing and the capturing of momentum that have the potential to add another 5 or 10 basis points to returns per annum.

Slow trading is a cure for what is called the ‘present moment bias’: the tendency for people to have a stronger preference for more immediate payoffs relative to later payoffs. It should be resisted, especially for people saving for their retirement. The short term outcome is of little significance to young superannuants. And even for those nearing, or in, retirement, investment should still be considered a long term process. Jumping in and out of markets trying to minimise losses or ‘take profits’ has been shown to be an unsuccessful strategy.

Diversifying is one way to slow down decisions, because different asset classes almost never re-price in the same way, allowing investors to take time making choices. Thus John Woods, Head of Asset Allocation at Australian Ethical, said in a recent interview that the fund is looking to diversify more by increasing the level of alternative assets:

“Defensive assets have lost some of their diversification benefits but we don’t lose sight of the primary role of fixed income assets is to protect capital. The income component comes second. It was great when defensive assets paid you to hold them but we haven't been in that environment for some time. Fixed income will still protect portfolios during severe equity sell offs.

“But we also need to protect against rises in real interest rates which permeate across multiple asset classes. We’re handling the need for diversification by bringing in new things, such as alternative assets. They comes with different equity risks than the rest of the portfolio, such as global businesses with a reasonable equity risk premium.”

That kind of diversification is harder for SMSFs to achieve than the big funds. But it is still possible to take the right amount of time over your decisions.

 

 

Reader note: This is general reporting only and should not be considered in any way to be investment or tax advice. It does not take into consideration the investment objectives, financial situation or particular needs of any particular investor. For more information please read our disclosure statement.

 

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