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The Behaviour of Rational Investors

A look at how human emotion and investor behaviour can affect markets.

Ben Graham, my friend and teacher … said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but … At times he feels euphoric and can see only the favourable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.”

Warren Buffet, Berkshire Hathaway Annual Report Letter to Shareholders, 1987.

Rational Behaviour v. Greed and Fear

The basic rule of economics is the rule governing the sensitivity of supply and demand to price fluctuations. Briefly, rising prices stimulate supply and suppress demand; falling prices suppress supply and stimulate demand. This is true across a wide sweep of human endeavour with one notable exception; financial markets.

Financial markets are perhaps the only sphere of human activity where rising prices stimulate demand, with buyers eager to gain exposure to an appreciating asset, and suppress supply, with sellers withdrawing from trades, holding out for a potentially higher price in the future.

This is then the first element of rational investor behaviour: a willingness and ability to observe and obey the fundamental laws of economics in responding to price signals from markets. That is to say, to operate within a disciplined framework that favours relatively better-value (cheaper) asset classes over relatively more expensive asset classes as a basis for adopting over-weight and under-weight positions relative to a given benchmark.

This is not easily done – “noise” from market volatility and a tendency towards copy-cat behaviour can cause investors to act in ways that do not favour a positive outcome for portfolio performance. Frequent trading can load up-front costs onto portfolios, diluting performance; crowd-following behaviour can  lead investors to increase exposure to assets near the peak price of the assets, lowering future return potential; and, frequent trading in and out of markets increases the risk of missing out on periods of market strength, thereby foregoing additional return and indirectly harming portfolio performance with notional “opportunity costs”.

Fortunately, this is not inevitable. Rational investors avoid common traps of irrational behaviour largely on account of a deep and abiding faith in investing for the long-term.

For example, an asset class with stable/improving fundamentals, stable-to-positive sentiment and attractive valuation could be expected to have a healthy performance outlook. Conversely, fundamentals that are peaking and about to roll over, sentiment that is at its peak strength and unlikely to go much higher and valuation that is, either in absolute or relative (or both) terms, at elevated levels are likely to result in a weaker outlook. However markets are volatile so nothing is guaranteed.

Measurement, framework, rule

A rational investor’s behaviour then has three key elements: measurement (such as fundamental factors e.g. company future profits and dividends growth), a framework within which to assess the value of that measurement and a rule that determines investor behaviour when certain conditions relating to the measurement and the framework are met.

A popular rule of thumb, by way of illustration, for investors in the 1930s-1960s was the Dow Jones Industrial Average dividend yield rule: this postulated that when average dividend yields (that is, dividend per share divided by share price) of stocks in the Dow Jones Industrial Average rose above 6%, it was likely that the worst part of a bear market was over and it was time to buy; conversely, when this measure fell below 3%, it was likely that the best part of the bull market was over and likely a good time to reduce exposure to equities. Here, the measurement was the dividend yield, the framework was the upper and lower bounds of 3% and 6% and the rule stipulated investor action when these bounds were breached.

One possible framework to assess financial assets

Most factors that determine financial asset prices can be classified into three: fundamentals (F), sentiment (S) and valuation (V). This F-S-V framework potentially offers a useful framework within which to assess the outlook for different asset classes needed to formulate investment strategy.

Fundamentals are measurable trends in the real economy, e.g. growth in gross domestic product (GDP), fiscal balances, trade balances, inflation, interest rates, house prices, jobs, wages, company profits etc. Different factors have varying levels of influence over asset classes e.g. jobs and wages will likely have a greater influence on equities than on bonds.

Sentiment indicates investor mood – are investors feeling optimistic or pessimistic? Anxious or exuberant? Risk-taking or risk-averse? Sentiment is difficult to measure, and can turn quite quickly and unpredictably. Some analytical frameworks try and measure sentiment using investor surveys, money-flows and differences between interest rates (interest-rate “spreads”) for lower-risk and higher-risk bonds etc.

Valuation is a yardstick for assessing fair value of assets and how much above (premium) or below (discount) fair value is current market price. In addition to absolute value, investors also use relative valuation techniques e.g. how expensive or cheap are equities relative to bonds? How expensive or cheap are they relative to their own long-term historical averages etc?

Summary

The question is frequently asked: is investment management art or science? It feels almost as though the unspoken wish is for the answer to be “science” so that a rule-based framework with measurable inputs and predictable outputs – not dissimilar to a laboratory experiment – can then become the intellectual analog for investors keen to maximise their chance of success in financial markets.

The truth, as always, is a little more complicated. Investment management is a science in terms of the required minimum measurable inputs – due diligence, long-term discipline, diversification, risk management and ongoing performance measurement. It is also an art, in that the outcome remains uncertain and, beyond a rough distribution of probabilities, essentially unpredictable.

A third pillar – in addition to the laws of economics and long-term investing – is portfolio diversification. Rational investors recognise that different market conditions and business cycle stages favour different asset classes.  While some of this potential ‘performance differential’ can be assessed in probabilistic terms, there remains a persistent element of uncertainty and unpredictability to the behaviour of financial assets.

Diversification can help provide an effective barrier to this and lowers overall portfolio risk due to the tendency of asset classes for periodically low correlation amongst themselves i.e. moving in relatively un-connected ways with respect to each other. This raises the possibility of some asset classes performing more strongly than others under certain market conditions depending on the prevailing business cycle stage.

Important information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed in this content.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this report are our in house views as at 24th April 2015 and should not be relied upon as fact and could be proved wrong.

The information contained in this content has been derived from sources which we consider to be reasonable and appropriate.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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