Pocket the unloved pawnbroker for its forecast upgrade and rerating potential
Emotion is often quoted as being the enemy of reason and investors are urged to check their emotions at the door when they trade the stock market.
Is this realistic or even preferable though? Perhaps it is more important that we are aware of our emotions. By understanding what motivates us when we invest we can avoid falling into some familiar traps and become more disciplined and profitable investors.
In the first of a two part series we will introduce the world of investment psychology before looking next week at a new product launched by asset manager Schroders - Income IQ - which helps you understand more about how emotion can affect you as an investor. As part of the analysis we will talk to some independent financial advisers (IFAs) about how best to make use of this information.
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Emerging science
Behavioural finance is, in academic terms, a relatively new subject that only got off the ground in earnest in the 1950s. A big breakthrough moment came in 1979 with the publication of Prospect Theory: An Analysis of Decision Under Risk - a paper by psychologists Amos Tversky and Daniel Kahneman. It argued that losses have more emotional impact than an equivalent gain.
The Open University’s Martin Upton, director of the True Potential Centre for the Public Understanding of Finance (PUFin), says: ‘It is important to understand the ways in which behavourial issues can affect investing as if these are not understood and dealt with, they can impair investment performance. Ideally you want to be making good rational decisions, understanding the pitfalls and devising strategies so you don’t succumb to it.’
Behavioural finance is focused on seven or eight core theories around investment behaviour and we will look to explain a selection of these later in the article.
Upton says individual investors are at a disadvantage to their counterparts in institutions. ‘In a well-run financial institution, sitting around you is an array of risk management systems which can negate the adverse effects of behavioural issues.’
Behavioural finance A to Z
Anchoring - becoming fixed on previous information and using that information to make investment decisions that are no longer appropriate. A good example might be continuing to buy a company which has historically delivered earnings upgrades through a cycle of profit warnings.
Confirmation bias - allowing your preconceived opinion to drive your analysis of an investment. If you have heard the buzz about a particular biotech stock you might, for example, choose to conduct your research to prove its potential is real rather than seek to challenge the ‘buzz’ claims.
Herd behaviour - the tendency to follow the actions of a larger group of investors perhaps because you think they must know something you don’t. During the dotcom boom people frantically put huge amounts of money into internet-related stocks even though they often had no track record of cash flow, profits or sometimes even revenue.
Overconfidence - the belief that you are better at others at choosing the best stocks. This might translate into frequent trading as you look to enter or exit the markets at the best possible time, potentially missing out gains from being constantly invested over the long-term.
Prospect theory - a loss hurts more than any pleasure you take from an equivalent gain. This could prevent you from running a winning position long enough but more damagingly could see you hold on to a position because you cannot face the ‘prospect’ of crystallising a loss.
Cold fish
But even the professionals are not immune. In a 2013 presentation, his colleague, professor Mark Fenton-O’Creevy, recounted how a novice trader had started out telling him he was a ‘cold fish’ who rejected the implication that emotions affected his decision making. Half an hour later the same trader was recounting how he had thrown up in the toilet when trading wasn’t going well.
Fenton-O’Creevy contrasts this scenario with the better performing traders. ‘The first thing we noticed is that the top performers are much more articulate about their emotions, and they’re much more willing to talk about them, and they think about them more,’ he says.
None of us are robots and nor should we aspire to be - the aim should be to control rather than eradicate emotion. Fenton-O’Creevy uses a simple analogy to explain the important role emotions can play in decision making. Driving a car is a cognitive process but over time it becomes automatic and ingrained. In his example he assumes you are an experienced driver, driving to work and you’re talking to a passenger, you’ve got the radio on and you’re not paying full attention to where you’re going when you see a small child run out in front of your car. At this point a surge of fear and adrenaline brings your cognitive attention to this potential emergency or in other words emotions are good for ‘helping us tell what to pay attention to’.
The accompanying graphic illustrates the emotions investors go through in different points in a stock market cycle or when investing in an individual stock.
To begin with ‘hope’ dominates before firming into ‘optimism’ and then potentially ‘excitement’ if corporate earnings arrive ahead of expectations. This can move to ‘thrill’ and ‘euphoria’, particularly if investing in shares becomes a mainstream topic. This is almost certainly the point of greatest risk.
Famously Joseph P. Kennedy, father of US president John F. Kennedy, sold all the stocks he owned just before the 1929 Wall Street Crash after a bellboy in a hotel began offering him stock tips. He decided if the bellboy was buying stock then it would be difficult to find someone who was below this lowly position to buy shares and keep the stock market momentum going.
At this stage investors are not focused on the possibility of losing money or the fundamentals behind a stock and instead fret about missing out on a potential opportunity.
Any bit of news at this point which falls short of these inflated expectations can act as the trigger for a correction. Investors will then go through the more negative emotional stages of ‘anxiety’, ‘denial’, ‘fear’, ‘desperation’, ‘panic’, ‘capitulation’, ‘despondency’ and ‘depression’.
James Rainbow
Head of financial institutions and strategic accounts at Schroders
‘A very common bias is an inability to project anything other than your current circumstances into the future. We need to get people thinking about how their circumstances will evolve and give them a more robust financial plan rather than one which is based on projecting today indefinitely. Our IncomeIQ tool is not a replacement for advice but a way of getting people thinking and raising awareness of the key issues.
‘All of us have an asymmetric attitude to risk, so losses hurt far more than any pleasure we take from gains. One of the key issues if people are going to carry investment risk into retirement by taking advantage of the new pension freedoms is they need to be clearly aware of the emotional reactions they might have if there’s a fall in the markets.
‘A fall in capital values will provoke an emotional response which is in some cases short-termist and the wrong one rather than keeping on track with a financial plan. We’re not robots, we will react differently to different circumstances - this is inbuilt into our individual fabric - but if we have a better understanding of the way emotions impact on us we are equipped to make better decisions in the longer-term.’
Riding the rollercoaster
How might this work in the real world? Gulf Keystone Petroleum (GKP) is a stock with a big private investor fan base and which has been extremely volatile in the past five or six years. A positive result from the Shaikan exploration well in Kurdistan, northern Iraq, in 2009 eventually propelled it from small cap to multi-billion cap status and we previewed the results from this well in August 2009 when the shares were trading at 12p.
In January 2011 we interviewed then CEO Todd Kozel and suggested investors should steer clear at 173.2p.
We were premature but ultimately not wrong. In early 2012 the shares moved higher on bid talk and further bullish drilling reports. After the shares briefly hit 400p the smart money started to exit the company with US fund manager The Capital Group cutting its holding by 2.25 million shares on 16 February 2012 when the share price was around 380p.
Gradually as commodity prices turned, progress in securing export payments from the Kurdistan Regional Government stalled and the company’s balance sheet came under strain the shares retreated and they now change hands for a mere 30p.
Can we use emotion to our advantage? When we turned negative on Gulf Keystone in January 2011 part of our reticence was due to a gut feeling that something just didn’t seem quite right about the business and we were also unconvinced by the-then chief executive Todd Kozel.
The Open University’s Upton says: ‘It depends. If it is based on experience that, for example, return on equity can be a useful metric when looking at a potential investment then possibly but if this gut feeling is based on a herd mentality - i.e. everyone else has bought this so I should too - then it is not helpful.’
In the Gulf Keystone example our ‘gut feeling’ was based on concerns over management attitude to risk, the inherent political challenges of operating in the region and technical issues with its drilling, all of which were borne out over time.
Exiting on our ‘gut feeling’ meant we missed out on backing the story all the way up to 400p but perhaps more importantly we weren’t exposed to the substantial sell-off which has ensued in the interim. In comparison, investors prompted by their emotions to follow the herd exposed themselves to the risk of significant losses.
The shares enjoyed two big subsequent leg ups - first in July 2012 when there was speculation over a takeover approach from ExxonMobil (XOM:NYSE) and then again in the latter half of 2013 after investor pressure prompted a boardroom shake up and success in a court case reaffirmed its ownership credentials on the Kurdistan assets.
