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How to be a human be-ing, not a human do-ing

We are so busy in our lives today. Decisions are made instantaneously, but knee-jerk reactions are often the wrong course of action. Taking the time to evaluate a situation can lead to a more informed decision and a better result in the long term. We are human be-ings not human do-ings; we don’t always need to be active and taking immediate action.

Quick decisions are often made because of fear. We are scared of failing or losing control. Switching away from a poorly-performing investment is a case in point, as it is human instinct to not want to suffer through poor performance.

It is very difficult to not look at short-term investment returns. During these periods many investors may be tempted to take swift action and switch out of a poorly-performing fund into a fund that has performed better. Although this may appear to be a sensible way to generate better returns, switching funds during periods of poor performance can destroy the value of your investment.

In order to switch, you have to sell your units, which will usually incur ‘friction costs’ (all the direct and indirect costs associated with a financial transaction, such as transaction fees and taxes). It also locks in the underperformance of the fund that you are switching from. At the same time, there are no guarantees that the fund that you switch into will be able to repeat its recent strong performance. By switching you are often selling and buying at exactly the wrong time.

Managing the urge to switch

There are many reasons why we switch. Next time, before we do it, it is worthwhile considering the following three factors to judge how much of a role they play in the decision making.

1. Our emotions. Market volatility is part of investing and unfortunately so is underperformance. You would not be human if this doesn’t create a sense of fear, or at least make you uncomfortable. These emotions often lead to taking action that will permanently lock in losses or missing the best time to invest.

Your role as an investor is to pick an investment such as a managed fund on the basis that it suits your needs and objectives and that you trust the fund manager – not solely on account of recent performance. If you can control your emotions, and hold on to that investment through the volatility, you have a better chance of achieving your objectives over the long term.

2. Forecasting. Driven by heavy doses of market commentary, investors often turn to macroeconomic factors to determine whether markets will deliver strong returns. However, various studies have shown there is no correlation between economic growth and share returns.

Using data from 46 countries, researchers from investment managers Vanguard found that the average equity market return over the long term of the countries with the three highest gross domestic product (GDP) growth rates was 4%. This was slightly below the average return (4.2%) of the countries with the three lowest GDP rates, despite a considerable difference between those GDP rates (8% a year versus 1.6%).

In the end, what determines the success of your investment is the price that you pay for an asset and how much return it generates for you.

3. ‘Black Swan’ events. In his 2007 book, The Black Swan, risk analyst Nassim Nicholas Taleb revived a metaphor first used by Roman poets. ‘Black swans’ are incredibly rare events that are difficult to predict and can have a major effect on markets and investments. Examples include natural disasters, or the September 11 attacks, and most recently, Brexit.

The impact on your portfolio from Black Swan events can be significant. They are highly unpredictable, however, and it is not a good idea to base your investment decisions on what could ‘possibly’ happen.

To benefit when switching funds, you have to be able to choose the best times to leave and enter the market. This is nearly impossible because markets can swing wildly from day to day in response to a variety of unpredictable factors.

Best action may be no action

Remaining invested when faced with poor performance will take strong nerves. But if you can steady your emotions and keep in mind the reasons why you invested in the first place, you can ride out a difficult period and hopefully enjoy good returns in the future. It would have been tempting to switch your investments in the final quarter of 2018 after a period of poor performance, but the S&P/ASX 300 Index was up almost 20% in the following six months.

Sometimes there are good reasons to switch. For example, if your objectives, or the fund’s objectives, change then your investment may no longer be suitable. You may have lost faith in the fund manager, or maybe you simply need to rebalance your portfolio.

Before making any decision, investing or otherwise, it is important to slow down, take time to re-evaluate the situation and focus on your long-term priorities. In today’s world the urge to take immediate action can be overwhelming, but sometimes the best course of action is to do nothing at all.

 

Julian Morrison is an Investment Specialist at Allan Gray Australia. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.

 

3 Comments
Allan Gray Australia
September 04, 2019

Steve, SMSF Trustee, thank you very much for your comments. In response to the comment from SMSF Trustee…

It is always a challenge to cover complex topics in a brief article and it does leave open the potential for ambiguity. The point you make around risk is sensible and important to address.

We certainly do try to think about all possible outcomes, even if they are considered unlikely. In particular those that are on the negative outcome side of the ledger – we do obsess about the downside. Our main point in the brief section on black swan events was that we do not make such events a central part of an investment thesis. We do however focus on the potential downside to each investment we make, including unlikely outcomes, and think about risk. Perhaps the most obvious way that is addressed for positions we hold is the management of position size.

On the specific point on AMP, it is debatable whether that should be referred to as a ‘Black Swan event’. In any case, this is an example of where we have built our position gradually, and managed the overall size to a level we deem appropriate given our assessment of potential risk, and potential return. Something we undertake carefully with every investment we make.

This is the type of subject where we could go into great detail and we would enjoy the opportunity to discuss it with you further, if you like. We don’t have your contact details but if you would like to call us on 02 8224 8600 we would be more than happy to chat.

Steve Darke
August 22, 2019

I don't think you can classify AMP as a black swan event. It has been a dud company for many years and obviously so. Contrarian investors might see some value there, but that's what defines them as contrarian. The article correctly states that portfolio construction shouldn't take into account black swan events, given their inherent unpredictability. How you prepare for something that no-one is able to predict?

SMSF Trustee
August 22, 2019

As an investor in Allan Gray, I really hope that they manage tail risk better than the article suggests, in the discussion of Black Swan events.

If an outcome is only "possible" and has small consequences if it becomes reality, then it's safe to ignore it in the investment strategy.
But if a possible outcome would have severe consequences, "possibly" wiping out a chunk of your capital, then it can't be ignored.

It's one thing to be a high conviction and contrarian stock picker like Allan Gray. It's quite another to manage investment risk recklessly. I'd appreciate a follow up comment by Julian to expand on his comments, especially in light of Allan Gray's investment in AMP which seems to have been an outworking of this 'don't worry about what's only possible' approach and is the reason they've underperformed badly recently.

 

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