“Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.”
Carl Richards
Over the last few weeks we have considered our process. This last blog falls under the title ‘repeat, repeat, repeat’. I was discussing our process recently and mentioned that the day we stop innovating and challenging is the day that we stop as complacency will have taken over, and this has the potential to destroy all the work we have done.
In July and August, I often breathe a sigh of relief. All the clients have agreed to the new portfolios and have been rebalanced into them. For two months I can effectively rest. In September I gear up to start the process again; hence ‘repeat, repeat, repeat’.
Behavioural Finance
This is nothing new but is something we all have a tendency to be swayed by. We would like to think we are rational, but the reality is often the opposite. Bolton and Woodford are two examples of fund managers who achieved the equivalent of celebrity status in the investment world. Everywhere you looked their new funds were being promoted, the press waxed lyrical about them and they even believed the hype. It is easy to see what they achieved and others rushing to invest meant that you didn’t want to miss out.
One aspect of behavioural finance are the positive feelings when markets are rising, compared to the negative feelings when markets are falling. The argument has always been that the best time to invest is in falling markets, but the reality is that most people will invest when they see markets picking up.
Recently I have been discussing Tesla shares with a friend who is a great fan of electric cars, and in particular Tesla who he believes will be the outright winner in the electric vehicle market. There is no doubt that Tesla is a “glamour stock”, everyone wants to own it. As the share price has risen quickly it is quite easy to follow everyone else, however there might be better opportunities within the electric car industry without taking such a risk. I am not saying my friend is wrong but when it is a stock that everyone wants, I’m more cautious and want to avoid the hype.
The point being that behavioural finance continues to be uppermost in our minds when we approach investments.
What does this mean?
It would be easy for us to do nothing; sit back and watch our winners rise and leave everything as it is. As we have highlighted there is a risk in doing this.
Our mantra is about growing people’s wealth slowly. We are not looking to make a bet on the market. Each year you can look back and think if only I had invested in Europe, or the UK, or bonds, I would have made a fortune, often the next move is to tilt your investments towards last year’s winner.
The problem is that if we are always chasing last year’s winner, we will often lose out. So implementing our process makes things simple, where each year we re-balance the portfolios. If we started with 10% allocated to the UK, and over the year this has drifted to 12% we sell down 2%. It seems counterintuitive to trim the top performing funds and invest in those that have underperformed, but because we don’t know what will happen next year, it is a disciplined approach to investing.
It is simple to retain those funds we started with. However, this may not work long term. We aim on average to get around 70% to 80% of the funds outperforming their index over a 3-year period. 80% plus would be a good average for us, and there are periods when this happens. But there are times when funds underperform especially over the short term, but it is the compounding of outperformance over 3, 5, 10 years that makes the difference.
If a fund consistently underperforms, we must go back to our rationale for investing in that fund. What has changed? We must speak to managers to try and understand whether this is a long-term issue or if there is potential for this to reverse.
As an example, there are something like 20 plus different investment styles. One of those is ‘value investing’, which suggests that cheap companies have the potential to outperform expensive companies. It is slightly more complicated than that but that is the theory. Value as an investment style has been out of favour for years, and yet the last few managers standing who believe in this think that this will change. In fact, I heard one manager explain that if you held his fund for 20 years there would be a period of around 18 months which makes all the money. The problem is that if you miss that period then you will lag the index. So, we are always asking ourselves whether you hold in the hope that things will get better, or do you go somewhere else.
Other examples to review are fund size; as funds grow, performance can fall away. Some managers actively close their fund to new money to ensure that they can continue to deliver performance to existing clients. Interestingly some managers are remunerated on the size of their fund, so it is in their best interest to grow the size of the fund as quickly as possible. There is also the question of what happens when the fund manager leaves or retires.
On the flip side, meeting 100 plus fund managers a year opens up opportunities and introduces us to managers that perhaps we have not considered in the past. Fund managers are very good at selling their services, and we must unpick this. We recently met a manager who was explaining his performance and outperformance since launch, 3 years ago. However, the outperformance only came in the last few months, which skewed the figures. We would prefer to wait to see consistency coming through.
Another example is where we have seen excellent performance, we want to understand where there is the potential for underperformance. It is very tempting to buy in when everything is going well.
Where does it all lead
Over a period of six months put together the proposals for the next portfolio. We may recommend no changes, but we go through the entire process to make sure we are doing what is right for client outcomes. We then build the proposed portfolios checking the potential downside risk, and upside returns.
We then outline these changes to clients. Once clients agree then we rebalance on 1 July. And then we repeat the whole process again.
Repeat, repeat, repeat
We started this blog looking at behavioural finance, and this is really important. We are not looking to create excitement; we are custodians of people’s wealth and our role is to protect and grow that. We don’t want to get sucked into the latest fad so sticking to the process, doing the research and repeating the process year by year we believe is the best way to achieve this outcome.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.