Making better investment decisions: start by getting off your rocking horse

With advanced economies still struggling to perform and investment markets showing uncertainty, investors would do well to stick to five tenets that will guide them through any investment setting and yield respectable outcomes.

1. Anchor asset allocation with desired returns

Substantial research shows that asset allocation decisions materially impact on the behaviour of investment returns. Indeed, the single most important decision for investors relates to their strategic long-term asset allocation. However, to be effective, a strategic asset allocation needs to appropriately reflect an investor’s risk profile, required investment return, life stage and ability to tolerate variability in returns, especially draw downs in portfolios.

The second most important decision that any investor will take is the decision to adhere to this asset allocation. Moving a portfolio, say, from a “risky” asset class, such as equities, to a more “stable” asset class, such as cash, will dampen a portfolio’s volatility during turbulent market conditions. This gives investors the illusion of safety as the portfolio’s behaviour becomes less volatile, but risk to investors has actually increased as they have moved their portfolio away from the asset class that produces the best long-term returns.

Investors who do this often enough, and for long enough, raise the risk of not achieving their long-term investment objective, and this is exacerbated by the fact that buying at the bottom of the market is difficult from an emotional perspective and almost impossible from a technical perspective. Investors will do best by using their strategic asset allocation as a guiding light in managing investments.

Of course, circumstances change, and it would be naïve to suggest that investment strategy is fixed for all time: investors should revisit the asset allocation strategy at certain intervals and adjust it as necessary but this should never be a knee-jerk reaction to market “froth” or “noise”.

2. Forget forecasts – they are mostly based on noise disguised as news

Accurate and reliable forecasting is notoriously difficult and bad forecasting leads to bad investment decisions.

Figure 1, drawn from James Montier’s work, shows that analysts struggle to get the absolute return figures reasonably correct: the forecast and actual columns seldom share similar magnitudes. Perhaps more notable is that there is no year in which analysts forecast a negative return for the market, whereas the actual market return was negative in four of the ten occasions. In short, forecasts are biased and wrong.

Figure 1: Analysts’ Expected Returns & Actual Returns (S&P500)

 (Click on image to enlarge)
Source: James Montier GMO (2009)

Figure 2, which is based on work by Russell Lamberti at ETM Analytics, depicts a similar poverty of forecasting in the South African case. The solid red line shows the actual path taken by the R/$ rate between 1999 and 2011, the black lines indicate the average analysts’ quarterly forecasts for the next two years.

What is evident from Lamberti’s work is that almost all of the time analysts do not even get the direction correct and, similar to the previous example, there is clear evidence of bias on their part: they consistently expect the rand to weaken.

Figure 2: Quarterly R/$ rate – Predicted vs Actual
 (Click on image to enlarge)

Source: ETM Analytics (2011)

Given the poverty of the predictions, investors are well advised to look past forecasts.

3. Stop switching – get off the rocking horse

Investors often confuse action with effectiveness. Doing something, for the sake of taking action, can be more harmful than doing nothing. Without a clear plan and an optimal strategy, an investor risks behaving like the proverbial headless chicken. There is no clearer example of this than the 2000-2002 collapse in technology stocks. As Figure 3 shows, in March 2000, as the technology company-encrusted NASDAQ Composite Index was reaching its all-time high, the largest-ever monthly inflow of $53 billion was recorded into NASDAQ stocks. Fast forward two years to July 2002 when the index was bottoming, and investors withdrew $49 billion from the market in that month, effectively five times the earlier inflow as prices had slumped to one fifth their previous levels.

Figure 3: NASDAQ Composite Index – 1990-present
 (Click on image to enlarge)

Source: Cannon Asset Managers (2012)

In each instance – March 2000 and July 2002 – investors were very active. But they were horribly unproductive in this trading activity, effectively buying high and selling low. Indeed, by being active in their portfolios, or “switching”, investors destroy wealth rather than create or protect it. Research shows that active switching costs a portfolio an average of 1.5% per annum in charges and performance which leads to a substantially reduced return over time.

This “rocking horse” method of investing involves the energetic activity of riding furiously on a horse which gets you absolutely nowhere. This gives the impression of activity, but in reality consumes energy and erodes returns.

4. Avoid expensive or hyped asset classes

Although what an investor acquires is a key consideration, equally critical is how much is paid for the asset. Buying a good business or a good property is one thing, but overpaying for that asset will result in a poor investment. So too with different investment markets: fast-growing emerging markets or fast-growing industries are not necessarily great investment cases. Just because a country or industry is showing rapid growth, it does not follow that its financial markets will perform well. To seek value in making a purchasing decision an investor needs to ask “is the price right?”

Investors need to seek assets – whether companies, properties, cash or debt instruments – that offer excellent value. These investments have two characteristics: they are great assets and this is not reflected in their price.

5. Hug attractive assets that are well managed

The fifth tenet urges investors to seek out those assets which are well managed and which offer value by being underpriced as a consequence of being unloved. Such assets exist in all market environments, and current examples abound within the equity environment in the local and offshore markets given investors’ anxiety about world economic growth.

An example is BMW, which is currently priced as if it operates solely in a European economy suffering from significant headwinds. Whilst the company certainly faces some headwinds, recent years have seen BMW’s sales in the developing world grow healthily, most specifically in China, such that the slow sales growth in advanced markets is being more than offset by growth elsewhere. In addition, BMW is a company of substance and quality: its operating margin is about 12%, which is robust for a company in this industry and points to a sound management team and good products. In addition, the share trades on modest multiples, evidenced by a price-book ratio of 1.4 times, an undemanding multiple for a business of this stature.

Any investor will appreciate that buying assets in tough times is hard, and staying with the investment can get even harder if times get tougher and a rocking horse is in sight. However, effective investing embraces the five key tenets of investing. When put together in this way, investing is straightforward, but the discipline required means that whilst investing may be simple, it is not easy.