Human nature is our worst enemy when investing
Human nature can be our own worst enemy when investing, because all too often people tend to go with the pack and believe the market hype.
In life, it usually makes sense to go with the crowd. For example, if you’re an engineer, you’d want to follow the consensus on what’s best practice in bridge design. And, when choosing a restaurant, you’d probably want to eat in one filled with people enjoying themselves rather than one that’s empty.
But this usually doesn’t work with investments.
People get overexcited about a positive story and suddenly everyone is competing against each other to buy a certain share and they bid the price up.
They buy on the same expectations as everyone else and if they are correct, it probably won’t help them a great deal because it’s already built into the price.
As a result, they are more likely to have overpaid for that share and thus risk a potential loss of capital. They may have bought a brilliant, profitable company but if the price is too high and doesn’t represent the company’s fair value, this will be recognised by the market sometime in the future. The share price will revert to its fair value and investors could suffer a permanent loss of capital.
While it is possible to overpay and still get your money back in time, you also need to think about what inflation will have done to your investment over the long term.
Other human “flaws” revolve around the way people view risk and allow this to affect their decision-making. They may take on too much risk because their expectations are too high or because they are overconfident and see less risk than there actually is. Conversely, they may not take on enough risk, especially if they have lost money before.
It’s also human nature to panic when a share price goes too low and they sell out too quickly. And, on the flip side, it can be tempting to buy more of an asset where the price has risen a lot.
At Allan Gray, we believe successful investing can often appear counterintuitive. As a result, our investment philosophy tends to go contrary to human instinct.
We never run with the pack - we usually buy when others feel the urge to sell. And if a stock falls further, we revisit our original valuation and the reasons why we invested in it. If that’s unchanged, we will often buy more. Our portfolio is usually filled with stocks that have been in the news for the wrong reasons.
Contrarian investing has been around for hundreds of years - it’s the basic idea of buying something when it’s cheap in a less optimistic environment and then selling it when things are on the up. But behaviourally, that doesn’t feel comfortable.
At Allan Gray, our confidence comes from knowing how these things have played out over many cycles. Our people understand that often the most challenging time for a stock provides us the greatest opportunity to buy it cheaply.
Our confidence also comes from our internal evaluations of the company and our belief in its fundamental strengths. If the company has more reliable or valuable underlying assets, you have a greater buffer and greater probability of a better outcome.
It’s also vital to have conviction and patience. But in the heat of the moment, stepping back and having discipline can be much harder than it sounds for most people.
It’s why we currently see good pockets of value in cyclical stocks, particularly in the energy and materials sectors. The valuation disparity between cyclical stocks and defensive stocks (such as healthcare and utilities), is the widest we’ve seen for years.
This large valuation disparity means many cyclical stocks are now significantly undervalued. As a result, for over a year, we have been increasing our exposure to cyclical companies and reducing our exposure to defensives.
The energy sector has been particularly depressed; it has underperformed globally with the energy sector index around long-term lows relative to the broader share market. Furthermore, many energy companies are struggling to make an adequate return at current oil prices.
As a result, Allan Gray finds energy stocks very attractive. And while there is always a risk to any investment, we weigh up whether we can be compensated for the risk by buying at a low enough price.
We believe that even if a few things go wrong for our energy stocks going forward, they can still generate reasonable returns. But the upside could be significant if a few things go right, or even just ‘less wrong’. This asymmetric payoff profile, repeated across many stocks, can help the portfolio deliver outperformance for clients.
We now have close to 20% of our portfolio exposed to the energy sector. The fall in oil prices, growing oil production from supposedly low-cost US shale, inventory builds, electric vehicles, and speculation on how climate change may impact the oil and gas industry have all soured sentiment in the sector.
But good investments often hide where sentiment is poorest. We think there will still be demand for the gas that the energy companies in our portfolio produce. And we have sought similar asymmetric payoff profiles in other areas of the market.
Things don’t always turn out the way Allan Gray expects. But we have outperformed the market over the long term to date. And, if we apply our approach consistently, we believe it should be possible to perform well in future – in large part due to the persistence of human behaviour.”
Julian Morrison is the national key account manager, Allan Gray Australia.
Recommended for you
Advice businesses that directly contract offshore workers are exposed to legal challenges in light of a recent Fair Work Commission decision, writes Danielle Cornelissen, CEO and founder of 5 ELK.
Referral arrangements with other professional advisers, known as Centres of Influence, can help financial advisers to build client relationships, engagement and trust over time.
One of the apparently happy outcomes of QAR Tranche 1 was the introduction of relief from having to provide a Financial Services Guide but it turns out this was not all it is cracked up to be, writes Samantha Hills.
With more women aged 35-50 engaged in their finances and investments than ever, the cohort is a growing demographic for financial advice firms to work with, writes Nina Kazmierczak.
