Category Investments

The downside of looking on the bright side of investment

12 November 2018 Simon Adler, Value Fund Manager, Schroders

So how do you reckon your life is going to turn out over the coming years? Would you predict, for example, you are going to be better off in five years’ time, than you are today?

If, on balance, you think, ‘yes, I probably will be’, then – with a caveat we will come to shortly – you are by no means alone for it turns out human beings are innately optimistic creatures.

Intuitively, of course, that does make sense – after all, the instinct that things will be better this time next year is a pretty powerful motivation to keep on keeping on.

Still, the idea of humans as eternal optimists also has strong academic backing from a paper published earlier this year by Nobel prize-winning economist Sir Angus Deaton.

As its title perhaps hints, What do self-reports of wellbeing say about life-cycle theory and policy? is not the lightest of reads. Here we are going to focus on its more general conclusions on “worldwide optimism about the future”.

This is, in a nutshell, that “in spite of repeated evidence to the contrary, people consistently but irrationally predict they will be better off five years from now”.

That said, the paper does find the gap between future and current wellbeing expectations does diminish with age – and, in rich countries, is actually negative among the elderly – perhaps suggesting you grow less optimistic (or more realistic) the longer you live.

While that in itself is interesting – especially given how, on average, people are increasingly living longer – two aspects of the paper really stood out for us, here in the Schroders Value Team.

The first of these is the extremely strong data set on which the research is based – using as it does more than 1.7 million Gallup World Poll observations gathered from 166 countries between 2006 and 2016.

The second aspect is the paper’s assertion that all this data reveals the pattern of human over-optimism is consistent across all regions of the world. The reason that particularly catches our attention is value investing is specifically designed to take advantage of extremes of investor emotion, including over-optimism – and that very quality is apparently to be found in spades in every market across the globe.

That is not to suggest value investors are not optimistic – obviously every investor has high hopes the stocks they buy will ultimately make them money – it is just that our high hopes tend to differ from everyone else’s.

Thus the wider market may focus on, say, technology companies with exciting (if perhaps unproven) growth stories or so-called bond proxies with attractive (if perhaps unsustainable) yields.

And their natural, inbuilt optimism for the prospects of these businesses may lead people to pay over the odds to own them.

While it may be intuitive to feel optimistic about such companies’ prospects, however, value investors know from more than a century of data that, over the longer term, the more profitable route is the counterintuitive one – that is, buying financially strong business that have fallen on hard times. It important to remember, of course, that past performance should not be used as a crystal ball for the future. 

As a rule, the wider market’s natural optimism tends to fail when faced with such prospects but that is what allows value investors to buy them more cheaply than we otherwise would.

And it is this margin of safety – in effect, paying a price that should be cheap enough to allow for a range of unexpected adverse outcomes – that is the basis for our own, admittedly counterintuitive, brand of optimism, here in the Value Team.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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