If it feels good, it probably isn’t

The concept of ‘herding’ is a powerful lesson that investors should not ignore. Herding is the bias that can lead investors to follow the crowd, whether they genuinely agree with what they are doing, or are just scared of being left standing alone.

Of course, herding had evolutionary benefits. Being swept along with the majority has ensured our species has survived as long it has. But the instincts that helped to keep our ancestors alive tens of thousands of years ago can be a positive disadvantage when it comes to modern-day investing. Acting in accordance with social proof – that is, going along with the crowd – makes people feel comfortable because, in evolutionary terms, it meant fewer life-threatening mistakes were made. Conversely, in the context of investment, in pursuing a value strategy, we are always looking to go against the crowd and to buy assets that would make most people feel deeply uncomfortable because that is where returns are to be made.

We seek to take advantage of investors’ low tolerance for short-term bad news and their tendency to extrapolate current trends when forming future expectations. This is most prominent during times of volatility when share prices move more than the real value of the companies they represent. At times of fear, investors look to sell shares irrespective of cheap valuations, thereby giving long-term deep-value investors the opportunity to buy bargains. 

Tune out the market noise

The only predictable thing about economic predictions is that most will be wrong – and those that do get lucky are seldom able to repeat their good fortune. Therefore, it is vital to explicitly avoid taking economic views that might influence portfolio decisions.

Multiple studies have shown that economists and pundits predictions are no better than tossing a coin. Moreover, availability bias means that forecasters usually stick too closely to the prevailing norms, and on those rare occasions when they call for change they often underestimate the potential magnitude. We are constantly reminded of the folly of forecasting. Oil declines more than expected but inflation is lower; new regulation is imposed out of the blue whilst events that appeared certain never come to fruition.

Despite overwhelming evidence against the veracity of predictions, humans are hard-wired to follow them. We seek cause and effect in random patterns and extrapolate them into the future, but we are doomed to fail because the future is not a fixed outcome; it is a range of possibilities.

It is therefore imperative to eliminate all emotion from investment; if it feels good it probably isn’t. But not knowing what the future will bring does not mean that we cannot prepare for it. Instead of relying on subjective forecasts, we base our investment decisions on long-term historical data and robust processes in order to determine instances where the upside potential exceeds the downside risk.

Bank stocks are cheap, but markets are still ‘anchored’ to old information

The past 11 years encompass most of the fallout from the worst lending, M&A and investment decisions ever made in banking history.  Vilified by the press – banks remain firmly ‘out of favour’ – but much has changed. Many banks are still perceived to have the risk profile that they had 5-years ago despite the significant tangible improvements that have occurred since. Selected banks are not only cheap but also have the potential to grow and sustain dividends in the coming years.

Take the UK banks for example. The significant capital that has been raised since the crisis hit mean UK banks’ capital ratios are now among the highest in the world; they have ten times the capital buffers when compared with 2007. One of the ironies of the credit bubble was that despite banks making extremely high returns, they were driven by taking on more balance sheet risk and not by high profit margins. Today, new lending is highly profitable and much better reflects the risks of the borrowers involved. For the time being these robust profit margins remain masked by losses on legacy assets and exceptional charges. Lessons from the UK banks sector have taught us that a banking recovery can take longer than expected.

Bank stocks generally have only been cheaper in early 2009 and late 2011 – at the height of systemic risk – and profitable new business is helping them build significant excess capital. In the short-term, they face multiple headwinds from litigation to regulatory uncertainty, while low interest rates continue to hamper profitability. The market has anchored on the current environment of low-interest rates and low profitability, which is suppressed by fines and hefty restructuring costs. Over the longer-term, however, we believe these headwinds will subside and ongoing the improvement in their core businesses will warrant significant share price increases.

For further insights from Schroders, please visit http://www.schroders.com.au/GlobalRecovery