No place for gut feel and human nature in volatile markets

In today’s increasingly volatile market, the safest solution for the prudent investor in lies in equity investment strategies based on numerical rather than judgemental analysis, such as quantitative investment techniques.

“That’s because people generally are not equipped to be good investors,” says Stephen Roberts, joint MD of Taquanta Asset Managers and head of the group’s Quants asset management operation. “We are subject to fear and greed, a need for pattern recognition and overconfidence. Indeed, it could be said that humans in general are hard-coded as poor investors – which is why judgemental analysis in times like these could be a recipe for failure.”

According to Roberts, most investors try to base their ‘picks’ of shares or funds on what they believe is their ‘intrinsic value’. The problem is that the intrinsic value of a share cannot be determined on its current NAV (net asset value): the most significant determinant of intrinsic value is future cash flows and this information is obviously not available to the market.

“As a result, market prices are relatively inefficient against true intrinsic value. While this creates the potential for alpha, because no-one knows the future, the potential for anyone to reliably estimate which share is relatively overvalued and which undervalued is limited,” he explains.

Despite this, most market participants overestimate their ability to estimate intrinsic value and to predict future events. In addition, investors operate in an environment where there are substantial pressures encouraging short-term performance thinking – agency effects, short-term performance evaluation, bonuses, peer recognition and career development.

Because of human nature and the pressure on market participants, market prices tend to overvalue recent information and trends, and undervalue long term information. Regret on missed opportunities also drives market participants to invest based on recent past trends. So market prices tend to be more volatile than the underlying true value because they are constantly adjusting to new information. Glamour stocks become overvalued due to market focus on them and ‘dogs’ fall into neglect.

“While market participants may strive to be rational, hard-coded emotional responses and pressures frequently lead to irrationality - until reality reasserts its influence leading to over-reaction and mean reversion cycles,” he adds.

Taquanta’s view is that ‘value’ is likely to beat ‘glamour’ over the long term – not due to any inherent virtue of the value metrics but rather due to market noise. Stocks which are currently market favourites tend to be over valued because of the behavioural biases of market participants.

The solution, Roberts maintains, is to strip all emotion from the investment process.

That’s where quantitative investment strategies come to the fore. Based on numerical rather than judgemental analysis, quant processes are objective and tend to focus on the full history of data available; judgemental processes are more prone to recency bias.

“Another advantage of quant processes is that they tend to be low cost. And when management fees and transaction usually result in the average asset owner earning negative active returns against market cap benchmarks, investors incurring lower transactions costs and with lower investment management fees will be at a significant advantage,” he adds.

“Price Indifferent Investment (PII) is a quantitative technique adopted by Taquanta that targets portfolio weights that are indifferent to price but are scaled with company size and liquidity. This results in minimal correlation to pricing errors.

“International research indicates that on a systematic basis one can exploit this tendency by building portfolios of shares not on the basis of their price but by using other measures that are indifferent to the price. Taquanta's own research in the South African market has tested the concept back to 1993, indicating that a price indifferent portfolio would have outperformed the market by about 3,5% per year,” he concludes.