Exploiting investor behaviour - Why time frames matter

Short-term investor behaviour can have a material impact on markets. A comprehensive literature review by the Centre for International Finance and Regulation (CIFR) summarises the costs of short-term investor behaviour as greater market inefficiency; excess volatility; procyclicality; less effective corporate monitoring; and less efficient intermediation due to additional costs¹.

Empirical evidence suggests that short-term investor behaviour can lead to sub-optimal performance outcomes. Research by Cremers and Pareek (2015) suggests that low portfolio turnover is a significant determinant of outperformance by active managers, when it is combined with a high active share (the proportion of stocks in a portfolio that differ from those in the benchmark). The researchers found that “only the most active and patiently managed funds have on average been able to outperform… We thus find that only active bets that were also patient (i.e. longer term) were rewarded in the markets, but find no evidence that active short‐term bets were profitable²”.

Research by Mercer found a strong tendency for active long-only managers to have higher turnover than they claim, resulting in high trading costs and a risk of misalignment between the client’s and the manager’s time horizon. Managers reported experiencing pressure from clients to demonstrate short-term outperformance against a benchmark³.

The current market environment has been bifurcated between two extremes. Earlier in the year, when news flow was supportive of an ongoing global growth narrative, market risk preferences gravitated towards companies with high earnings growth and momentum - without consideration to valuation.

For example, in Japan, this was most pronounced in a narrow group of technology-related stocks. In Fig.1, we compare the valuation for auto stocks in Japan which have become significantly mispriced in response to shifts in shorter-term market risk preferences. On the other hand, more recently news flow has challenged the status quo for growth, and market risk preferences have swung towards more defensive companies with perceived shorter-term earnings certainty and earnings visibility - again without consideration to valuation. Valuations are now at episodically expensive levels for both these segments in Japan, which suggests the risks are to the downside. In Fig.2, we compare these “expensive Defensives” with the Financials sector which have become mispriced in response to the market’s entrenched beliefs around the permanency of the Bank of Japan’s negative interest rate policies and the extrapolated beliefs around the implications for earnings.

Amidst this narrow market environment, where very expensive stocks are driving price momentum, a common question that has been raised by our clients and stakeholders is, “what are you doing about shorter-term performance?”

At Eastspring Investments, we believe what you choose to do or not to do in decision making are both equally important. It can mean the difference between demonstrating skill – which is repeatable – or being subject to luck – which is random and temporary.

When faced with common influences such as complexity, ambiguity, time pressures and uncertainty, decisions can become mentally and emotionally tough to manage for all individuals. To ease this mental stress, we are all subject to subconsciously reverting to our strong personal preferences to form our decisions. Our personal preferences are subject to cognitive bias, and when left unchecked, we are all prone to judgment errors.

To highlight this, and at the risk of overdosing on football with the FIFA World Cup fever behind us, we are reminded of a well-known study of professional goalkeepers and their drive to ease their own mental stress through action bias or the need “to do something”.

Imagine you are a goalkeeper in the final minute of a crucial World Cup match. You are about to face a penalty kick and the result hangs in the balance. If you save the penalty kick, your country moves into the finals. If you don’t, you are on the next flight home…

You have no idea which way the penalty taker will choose to direct the kick. You effectively make your decision simultaneously with the kicker.

Should you dive left, right, or stay where you are in the centre of the goal?

The study⁸ of professional goalkeepers found the following results around their behaviour:

The stakes are high… goals are scored 80% of time from penalties

What is the optimal strategy?

But the goalkeeper rarely stays in the centre at around 6% of the time.

Goalkeepers feel like they are making more of an effort when diving left or right. Whilst a diving save may “feel right”, it is clearly the statistically sub-optimal strategy. The weight of probability strongly suggests staying in the centre is the best strategy. Despite this, when goalkeepers were asked why they chose to dive, the common response was that standing in the centre makes you “feel” much worse. Following the optimal strategy may be emotionally hard to do but is likely to pay the greatest rewards over the longer term.

The persistence of judgmental errors in the market can drive prices to the extremes of both expensive and cheap. This is the market behaviour we observe today, and this brings significant price opportunities that our contrarian approach can exploit.

In making skilful investment decisions, we need to identify a way to put the weight of probability in our favour. We need to mitigate the potential for errors in our judgment. We can achieve this by adopting a carefully conceived decision process that anchors our judgment. Our approach is to consistently apply a disciplined valuation approach to anchor our own judgment in exploiting opportunities driven by investor behaviour in the market.

We accept that it is extremely hard to be more “informed” than the market and we do not rely on forecast accuracy in our analysis. We humbly understand the limitations of our knowledge. We believe it is better to be approximately right than precisely wrong.

A patient time frame can improve the probability of outcomes. We therefore require a significant trend valuation upside to compensate us for two key risks:

1. The future is inherently uncertain, and this requires our approach to adopt a significant margin for safety in estimating the trend valuation upside.

2. Market behaviour may persist, and assets may remain out of favour for an indeterminate length of time. Significant valuation upside compensates for the time it may take for the market to realise value in an asset.

A high valuation upside offers a significant margin for safety and is an acknowledgment that our approach does not rely on forecast accuracy. A high conviction around trend fundamentals enables our approach to remain patient amid market uncertainty and to exploit shorter-term price volatility in a contrarian manner.