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Don’t follow the investment herd

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AR011053 12/2017

Giles Parkinson

Giles is a Fund Manager at Aviva Investors, responsible for the management of our Global Equity fund range and lead manager on our Global Equity Endurance strategy. Holder of a BA in history and an MPhil in historical studies, Giles now looks ahead to help our customers look after their futures.

Don’t follow the investment herd

Let’s start with a lesson from history. Back in the 1930s, when Singapore was threatened with attack from Japan, imperial planners in London spent a fortune turning the area into a supposedly impregnable fortress. But there was one vital flaw to their plans - all the big guns faced out to sea as nobody thought the Japanese would attack overland through the jungles of Malaya. The rest is history. Singapore fell, sounding the death knell for hundreds of years of British dominion over the Far East.

It’s a lesson in complacency that professional investors too can be guilty of too. Their behaviour creates opportunities so long as you avoid falling into the same traps.

Don’t be too sure

Overconfidence is one of the biggest dangers. Worryingly, numerous studies have found experts tend to suffer more from this flaw than lay people, and fund managers appear to be no exception.

One of the consequences is that most fund managers and analysts continue to place forecasting and detailed financial modelling at the heart of their investment process, despite repeated studies showing they are actually not very good at predicting the future.

For this reason we do not use share price targets. However, just because you can’t measure a company’s intrinsic value with precision does not mean you shouldn’t consider it. I like to think in grey terms of whether a share looks ‘cheap’, ‘expensive, or ‘fair’. Companies’ values, and hence the relative attractiveness of different investment opportunities across the market and within a portfolio, constantly evolve.

Plough your own furrow

One of the most infamous financial events in recent memory was the bursting of the so-called dot.com bubble in early 2000. Many put the bubble down to the tendency of individuals to mimic the actions of a larger group.

When it comes to investing, one of the dangers posed by herd behaviour is that it can result in fund managers adopting similar positions to one another for fear of underperforming the peer group. For example, tasked with outperforming the FTSE-100, the tendency is to invest in all hundred stocks, with a slightly larger or smaller `weighting` than the index. The result is a portfolio that minimises differences with an index because to deviate from this benchmark becomes the definition of risk. 

A more sensible way to invest is to start from what stocks you want to own regardless of their size, geographical location or sector, and then designing the portfolio to achieve a particular outcome, such as generating income or capital, or even both. This also helps to overcome ‘home bias’, whereby investors have an oversized allocation to equities in their domestic market and are irrationally reluctant to look elsewhere.

Taking things for granted

Anchoring, which refers to a tendency to attach or ‘anchor’ our thoughts to a reference point, even if that reference point is neither logical nor relevant, is another common pitfall. For instance, the price you paid for a particular share ought to count for nothing. The only thing that matters is the prospective return that stock offers.

Similarly, in the event the market has suddenly risen, there will be a temptation to hold back from investing new cash that has come into the fund in the hope shares will fall back to their previous levels. As a result, you may end up ignoring the fact there are good reasons for the market to have gone up and be left behind.

All of this is not to deny that beating the market remains extremely difficult. However, there is plenty of evidence to suggest humans are not the rational actors assumed by conventional economic and financial market theory. Whilst this presents investors with an opportunity, in order to maximise the chance of outperforming the market over the long run they need to develop an investment process that takes account of, and avoids, some of the pitfalls common to us all.

Or to put it another way, make sure your guns aren’t just facing in one direction.

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