Share markets around the world have had a shaky start to 2016. Fears over a slowdown in Chinese growth, falling commodity prices and speculation over US monetary policy have all contributed to the volatility.
Volatile markets create uncertainty amongst investors and we know that uncertainty can cause anxiety. Investors are often intolerant of uncertainty and may become more susceptible to reacting emotionally.
This cannot be helped as it’s a human trait; when nervousness increases, even in the absence of any new facts, people will often look to what others are doing as the basis for their own decision making. These shortcut conclusions without a clear basis are the result of natural human behavioural biases.
This is why herding is a common feature of investment markets, particularly when general sentiment becomes more extreme. It can lead to poor outcomes for investors, especially when perceived uncertainty is causing asset prices to fluctuate more violently. A sound, long-term investment may be sold in a moment of panic, crystallising what might otherwise have been a temporary, unrealised loss. This behaviour also risks foregoing longer-term gains, which only just previously had been the objective. Of course, when markets are performing strongly and shares that performed well in previous years continue to perform while those that performed badly continue to underperform (known as market trending), following the herd can be profitable for some investors. But it is very difficult to predict when this strategy will be effective and it’s not an approach we pursue.
The temptation to sell rises
In times of market stress, when uncertainty clouds the decision-making process, it’s important to go back to basics. We need to turn off the ‘noise’ and revisit why we made an investment in the first place and also why we maintained our position. There are five questions we think investors should be asking themselves:
- What is the timeframe for this investment?
- What attracted you to the investment? (e.g. valuation, business model, leadership team)
- Has the investment continued to be managed in the same way?
- Is the investment’s timeframe aligned with your original intention?
- If you previously assessed there is a basis for this investment to prove enduring over time, has anything changed?
If the answers to these questions hold true, then there is a high probability that a sell decision may later prove to be an untimely, emotional response.
In the short term, performance has as much to do with the aggregate emotions of investors as a group, as it does with the skill of an individual investor. If consensus is to sell a share it’s hard for the price to rise, regardless of the quality of the company and this can often lead to underperformance in the short term. Skilled investors who have the required temperament will show conviction and adherence to their planned strategy through tougher times and only make a decision to sell when it is logical to do so. Showing similar conviction may well prove the greatest ally in combating those innate behavioural influences.
Volatility can lead to opportunities
Benjamin Graham in his book The Intelligent Investor discusses how volatility can be beneficial, as it presents opportunities to buy high quality investments at bargain prices. The point he makes is that investors shouldn’t let short-term market volatility affect their long-term investment decision making. But, as he explains, the investor’s chief problem is that, when confronted by complexity and uncertainty, emotion takes over and decision making becomes less rational.
We remind ourselves that during these periods of uncertainty volatility shouldn’t be feared; opportunities to find quality investments at a discount still exist. Indeed, such opportunities may be more prevalent at times of emotional distress. The contrarian approach seeks to find such opportunities that are available at bargain prices due to sentiment-driven sell-offs.
To behave differently to the consensus of the crowd in the face of uncertainty requires accepting discomfort. But this is the only way we know to reliably reduce the competition to buy at bargain prices, and thereby allow for higher-than-average future rewards.
Be prepared to feel uncomfortable
Periods of underperformance are no surprise to a contrarian manager; we have seen them before. In these circumstances it’s important to be properly prepared ahead of time, to be ready to revisit the reasons you made an investment in the first place. And, although it may feel uncomfortable, it’s also an opportune time to look for bargains amongst the volatility, or you might find yourself trying to catch a train that is already rolling ahead.
Joy Yacoub holds a Bachelor of Economics and a Bachelor of Commerce (UNSW), specialising in Economics, Finance and Business law.