Investors: Learn To Control Your Emotions
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The Economist magazine this week discusses what it calls "the rational response to terrorism". At the risk of appearing either morbid or inappropriately materialistic, there are almost certainly parallels between our reactions to the current geopolitical climate and our responses to perceived threats in financial markets.
Gary Becker of the University of Chicago and Yona Rubinstein of Tel Aviv University have studied ("Fear and the response to terrorism: an economic analysis") how the general public reacts to the threat of suicide bombers. Some might view this as a grotesque departure from the realm of 'traditional' economics. We would argue to the contrary that, as with Steven Levitt's excellent "Freakonomics", this is in fact a refreshingly relevant application of a discipline too often in danger of disappearing obliquely up its own fundament.”
Becker and Rubinstein suggest that people don't change their behaviour as a result of perceptions of the risk of physical harm, but rather out of plain emotional upset. As The Economist puts it, "People respond to fear, not risk." It is a truism of financial markets that they reflect at a very fundamental level the human forces of greed and fear. (Economists might prefer the coinages 'supply' and 'demand'.)
This message is not necessarily accelerated sufficiently rapidly toward students of economics courses, who sometimes complain on entering the City that they feel obliged to 'unlearn' much of their coursework because it simply has no practical application within a dealing room. The motivational power of greed is relatively straightforward to understand. Investors are keen to jump onto any bandwagon that dangles the prospect of easy enrichment. Investors are also keen to take profits - and sometimes too keen. But when it comes to the motivational power of fear, the picture gets cloudier. What are we all so afraid of? As far as risk is concerned, the general types of investment risk are well known, and include market risk (which is, to an extent, simply 'noise'); interest rate risk (which US investors currently ignore at their peril); inflation risk; credit risk and currency risk (all of which are being strangely discounted by bond market investors and particularly US Treasury investors at present).
Both market- and default risk can be addressed and mitigated through simple diversification, whether at a security specific level or at an asset class level. At the level of specific securities, however, many supposedly professional investors are probably too highly diversified to be operating optimally. What is the point, for example, of an 'active' fund manager owning every stock in the FTSE 100 index? By that stage, he has BECOME the market.
Given that sufficient diversification can be achieved by holding as few as 16 securities and given that expert knowledge of corporate value has to be a finite resource, there is surely at least as much merit in portfolio concentration as opposed to diversification. At the asset class level, diversification carries more compelling benefits and an unconstrained investor has a wide choice, including listed equity, private equity, debt, property, commodities and the somewhat nebulous variety of trading strategies that come under the blanket identifier of hedge funds.
One could argue that the stupendous flow of capital into the hedge fund sector has been triggered primarily by fear - fear that major equity markets might continue the poor run of returns that began in early 2000. (Becker and Rubinstein define the fear of terrorism as "extreme fear caused by small probability events", which doubtless has some overlap with concerns over movements in asset valuation.) But that fear is at least partly irrational (as so many fears are), and fundamentally ignores the fact that disciplined stock-picking, for example, can generate returns significantly superior to those of falling equity markets.
Some hedge fund managers, of course, will be generating high alpha returns, and they deserve the big bucks that they will invariably be earning. The problem is that a selection of rather complex investment vehicles (equities; hedge funds) are being crudely treated as homogeneous asset classes. The risk that many asset allocators have created for themselves is that they have voluntarily positioned themselves as overweight fundamentally less attractive assets (e.g. bonds or poorer quality hedge funds) and underweight fundamentally more attractive longer term assets such as 'value' equities (however defined). The solution, as proposed by Becker and Rubinstein, is rational, and derives from self-education:
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"(investors can) overcome their fear by accumulating mental skills and not by understating the objective probabilities."
Becker and Rubinstein must be correct in a broader sense. Investors, too, respond to fear more than risk. When the former outweighs the latter, returns are going to disappoint, and the paucity of those returns will be directly linked to the severity of those largely unwarranted fears.
In a related study cited by Barry Ritholtz, the largely malign role played by fear upon investing has also been highlighted:
"people with brain damage that impaired their ability to experience emotions such as fear outperformed other people in an investment game."
The bottom line is that learning to control your "emotional responsiveness" is an advantage when investing. You are more willing to take calculated gambles with high payoffs when you control fear. Too much caution and being overly reactive to your emotions will hurt your performance. "Some neuroscientists believe good investors may be exceptionally skilled at suppressing emotional reactions. "It's possible that people who are high-risk takers or good investors may have what you call a functional psychopathy," says Antoine Bechara, an associate professor of neurology at the University of Iowa, and a co-author of the study. "They don't react emotionally to things. Good investors can learn to control their emotions in certain ways to become like those people."
The idea that brain damage can lead to superior investment performance will no doubt appeal to many conventional fund managers. Particularly to those long-only failures that have lately, and somewhat amusingly, found hedge fund religion.
Tim PricSenior Investment StrategisAnsbacher & Co Ltd
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