Critical Considerations

The following relevant information on investments and investment behavior I have extracted and condensed from DYNAMIC WEALTH LISTED PROPERTY WEEKLY REPORT 21-25 JULY 2008 into what I believe to be critical considerations to share with my clients.

INTEREST RATES

The direction of the interest rate cycle is of the utmost importance for investors, as interest rates affect all types of investment classes.

Rian Le Roux from Old Mutual said that interest rates might fall faster than previously thought, because of lower inflation. Le Roux expects that the CPIX will peak at 13.5% at the end of the year. Le Roux predicts that the first interest rate cut could be expected by the middle of next year. He is also of the opinion that a recession is unlikely, although certain sectors, such as car sales, residential property and durable goods are experiencing an economic downturn.

UNIT TRUST INFLOWS AND OUTFLOWS

Peter Brooke of Omigsa identifies a ‘reinvestment risk’. He explains: ‘With the change in the inflation basket, we should see inflation coming into the [Reserve Bank’s target] range at the tail end of next year. That creates the potential for interest rate cuts. Once interest rates start falling your return on cash becomes less attractive. You need to have a mix of growth assets within your portfolio.’
Brooke says he is not saying investors should blindly buy the market. Rather, he is concerned that investors are heading in the wrong direction. ‘Over the next year, 18 months, you’re going to be getting some great opportunities as the economy deteriorates and the bad news comes through and money should be coming out of cash and buying assets then. Whereas what’s really going to happen is people are going to be seeing the bad news and going the wrong way.’  (Source: Omigsa, published on Moneyweb and Equinox websites) 

SOME INVESTMENT ADVICE
 
Various academic studies have shown that investors tend to ‘overtrade’ and try to time the market, with detrimental impact on their long-term investment returns. This is especially relevant in the current volatile and uncertain market conditions where investors tend to withdraw their funds from a general equity fund in response to recent negative returns from that fund (the listed property sector is a case in point). However, the problem is that they tend to move their money to the ‘wrong sectors’ or keep their money in cash or a money market fund for too long. They then usually return to the general equity market when prices have considerably increased already, reducing their long term gains.

The lessons are clear:
Remember that investment is a long-term process.
Do not place too much emphasis on recent return figures
Be careful to remove your money form a sector that recently recorded negative returns (for example financial and listed property) to a sector that recently recorded good gains (most notably resources).

Unit trusts are seeing strong inflows in the sectors that have done well in the past five years, while interest in the groups that have done poorly is sparse. For example, at the height of the technology and telecom bubble in the first quarter of 2000, investors poured a record $140 billion into growth funds while pulling $40 billion out of value funds. In the subsequent five years, value funds substantially outperformed growth funds.
As Bill Miller noted, ‘people want to buy today what they should have bought 5 or 6 years ago; call it the 5 year psychological cycle.’

South African retail investors also continue to show signs of following past winners, buying high and selling low. This is ‘absolute insanity’, notes Peter Brooke, head of macro strategy at Old Mutual Investment Group (SA) (Omigsa). Brooke notes that there has been ‘investor stampede’ out of non-cash unit trusts. This comes after a hefty fall in prices. Meanwhile, the money that is flowing into share-based unit trusts is going into top-performing funds. ‘Resource funds have experienced R1.1bn in inflows in the first half of the year (while prices are high), financials have seen outflows of R0.5bn (while prices are low), and property has experienced the largest outflows on record – yields are now at highs not seen for many years,’ noted Brooke at a quarterly media presentation.
‘This type of ‘late momentum’ investing will not generate sustainable returns and highlights the risk of retail investors trying to time the market.’ Brooke says he’s concerned that people are investing by looking in the rearview mirror and moving out of growth assets into cash when they should be doing the exact opposite.

A fascinating and relevant line of research addresses the effects of stress. For most animals, physical threats trigger the stress response. If and when the threat passes, the animal settles back to a balanced state. Humans generally face psychological stress, though we still respond physically by pumping blood, releasing adrenaline, sharpening senses, shutting down long-term operations like digestion, reproduction, and the immune system. The problem for humans: psychological stress is often chronic. As a result, the body finds itself in crisis every day. Stress mobilizes you for the short term and ignores the long term. Just as there is no use worrying about next week if a lion is chasing you, there is no need to consider three-year investment returns if you are likely to get fired for poor three-month results. Heightened stress undoubtedly encourages a short-term mindset.

Another problem is the amount of ‘information’ and news investors are confronted with every day. Naturally, an investor requires information to make decisions. But investors must also make a crucial distinction between noise and signal. More information creates more noise and more market reaction, without generating insight or value.
Reflecting on the above, the evidence appears to confirm the case:  investors are human, driven by ‘animal spirits’. However, these ‘animal spirits’ carry across into the investment decision process, such that various biases are introduced in the management of portfolios. The greater extent the investors are aware of their biases, the greater their ability to cater for their partiality and so recover investment performance.

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