Investor behaviour in uncertain times

In the short to medium term, markets are driven by an unholy combination of investor sentiment and fundamental analysis. The more at peace the world feels, the more weight is given to fundamentals, whereas when uncertainty prevails it’s sentiment that drives prices.

In recent times uncertainty has certainly been the driving factor for markets. A quick assessment of the last couple of years and we have had a global health pandemic, massive unprecedented stimulus packages, the first war in Europe in 30 years, the breakout of hostilities in the Middle East, threats from an ever-emerging China, and a global inflation (and debt) problem that no one seems to have a solution for.

Risk vs Uncertainty.

Yet, it’s important to note that when it comes to investing, uncertainty is not the same as risk.

Uncertainty is a driver of sentiment, it creates angst and ecstasy, influencing decision making in a way that is unhealthy for the investor’s returns. It is unknowable, and by definition is unmeasurable. Uncertainty fills the pages of newspapers and takes up time on TV talk shows. It is the driver of ‘animal spirits’ and bears little influence on the long-term outcomes of investing.

Risk on the other hand is identifiable and measurable.

Measuring risk: When rolling dice or spinning a roulette wheel, players understand that they have a 1 in 6 (or 1 in 38) chance of rolling a particular number. There is no certainty that the player will roll the number they want, nor is there a guarantee that 6 rolls will guarantee their outcome, but the odds are measurable and understandable. Similarly, when investing, investors can gauge a company’s earnings, and based on all the information available, they can make a reasonable assessment of the business’s likely future prospects.

Measuring uncertainty: Measuring uncertainty is almost impossible. Whereas the above illustration gives a practical application of measuring risk, the measure of uncertainty would be like trying to assess the chances of the dice landing on a point, or being snatched away by a cowboy riding a horse before the player has a chance to see the outcome. There is no actuarial procedure that can account for horse riding cowboys snatching dice.

But unimaginable events do occur. They occur all too often. Weather events see insurance companies who take otherwise sensible bets on likely disasters hit by ‘unprecedented’ events leading to heavy payouts. Terrorist attacks, wars, and global pandemics have all occurred over time, each time opening investors eyes to the possibility of the ‘impossible’, each time driving investor sentiment and share prices lower.

Investors often make the mistake of falling into the trap of recency bias (as described in my last article). When unexpected events have recently occurred, investors cannot see beyond the ambiguity of the current status. During these times, investors are unreasonably pessimistic about the outlook for stocks. Good news and bad news are not weighted equally (as they should be). Instead, studies have shown that in times of high uncertainty markets and investors seem to (at the extreme) totally disregard any positive news, while simultaneously giving undue weight to risks or actual bad news.

This psychology is apparent in good times as well, but the impact on investor behaviour is less stark in the good times as compared to poor times.

Impact of ambiguity

In their book Ambiguity and Investor Behaviour, Steffen Meyer and Charline Uhr assess investor appetite for ambiguity (uncertainty) and its impact on their investing behaviour. They found that almost 60% of investors are ambiguity averse, while only 28% sought out ambiguity. The impact of these positions was that ambiguity averse investors were likely to drastically increase the rate of their trading – exiting positions they viewed as risky during periods of uncertainty, Ambiguity seeking investors would also increase their trading activity - buying stocks they view as opportunistically priced. The net impact on markets from all that activity is significantly to the downside as uncertainty leads to selling which leads to more uncertainty and a self sustaining cycle of fear and pessimism.

Our thoughts (Uncertainty for Value investors):

When I first sat down to write this article I had thought to make the case that value investors ought to disregard the concept of uncertainty/ambiguity in markets. I had expected to make the case that it is precisely the ambiguity in markets that provides the opportunities we fundamental value investors look for. And fundamentally I do believe that to be true. I truly do believe that ultimately the price of a share will reflect the value of its cash flows over time. I do believe that critically considering an investment is the only way to understand its value and gain the conviction needed to make and maintain an investment.

However, I think it’s equally important to recognise where my bias lies. Our team are a unique bunch. We love digging up ideas in unexpected places and view ourselves very much as contrarians. I have no doubt that if Meyer and Uhr had interviewed the team at Collins St, we would have fallen very much in the minority (ambiguity seekers).

It’s unreasonable to expect all investors to be comfortable in the same spaces as we are.

There is a cohort of investors (probably the majority of individual investors) that can’t help but follow their gut. They sell when markets are uncertain, creating selling pressure on top of selling pressure, locking in losses, and buy only where there is ‘clarity’ in markets long after the rallies have played out. It’s unsurprising then to note that studies have shown that most active non-professional investors significantly underperform the shares, indices or managed funds they invest in.

The challenge they face is that it is precisely at those times where it feels most uncomfortable to invest (when uncertainty is at its highest) that the greatest opportunity lies just around the corner – this is especially true given how quickly markets can move and how much of long-term gains are actually realised during relatively short periods of time.

Nevertheless, it is important to recognise the impact that uncertainty can have on markets. This is especially true when making investments based on near-term expectations.

Our preference at Collins St is certainly to invest in good quality companies for the long term, but we do occasionally invest in special situations with near term expectations. Those investments with near term catalysts are especially susceptible to the influence of uncertainty. When relying on a near term outcome, we don’t get the benefit of time (a good businesses best friend). Instead we are somewhat at the mercy of whatever market spirits rule the day.

Our Key Takeaway:

Before making any investment it is important to determine how much risk you are willing to take and how much ambiguity you are prepared to accept. The problem for fundamental investors, however, is that ambiguity is infinite and unmeasurable.

So what can you do?

At Collins St Asset Management we believe there are three key things people can do that can shift the dial and influence better investment outcomes:

1. Be realistic about your investment time frame and be patient. If short term swings in asset values cause you angst and tempt you to cut and run, then perhaps such assets are not for you, and should not be speculated upon.
2. Be aware of your biases and have your thinking challenged regularly. The first step to solving a problem (or mitigating a bias) is to recognise one exists. As problems can rarely be solved within the framework that created them it can be useful to have someone you respect challenge your thinking and play 'devils advocate' so as to identify in blind spots in your research process.
3. Be comfortable feeling uncomfortable. If you identify a blind spot in your research or you are unsure about what the impact of something might be on your investment thesis ask yourself the question, what else do I need to know to prove or disprove this point and how can I get that information? Sometimes this might lead you down some unconventional rabbit holes however it is only by doing the sort of research others won't that you will arrive at the sort of investment outcomes that other's don't!

Implementing these three ideas is not easy and may take years of refinement before you finally get it right, however it is a far easier way of investing than trying to solve the problems of the world, one pandemic and one war at a time, before deploying capital in the pursuit of your personal ambition and future aspirations.