You know the generic joke that begins “How do I get to wherever (Dublin, Timbuktu, you name it)?” The idiot-savant reply – “Well, I wouldn’t start from here” – now has a special application for equity investing. The trouble is, lots of people did start investing from 2020 or thereabouts, so it would be understandable if they were feeling a little lost.
As the table shows, they started in a year when equity markets the world over did their impersonation of Blackpool’s ‘Big One’ rollercoaster. The maths doesn’t need to be complicated to indicate the G forces investors had to cope with. For each year, simply divide a market’s low point into its high point, then compare ratios. Using data for the FTSE 100 index, 2020 is easily the most volatile of the 10 years from 2011 to 2020; its peak level was 1.54 times higher than its lowest daily close. For a bit of sophistication, take a conventional measure of volatility – the annualised swing around the 30-day rolling-average price change – and 2020’s maximum volatility was almost three times higher than the average maximum of the previous nine years – 76 per cent against 27 per cent.
| Don't start from 2020 | |||||
| FTSE High | FTSE Low | Ratio high to low | Max Volatility (%) | Min Volatility (%) | |
| 2011 | 6,091 | 4,944 | 1.23 | 42.8 | 14.7 |
| 2012 | 5,966 | 5,260 | 1.13 | 23.2 | 6.7 |
| 2013 | 6,840 | 5,898 | 1.16 | 24.9 | 9.2 |
| 2014 | 6,878 | 6,183 | 1.11 | 21.0 | 6.4 |
| 2015 | 7,104 | 5,874 | 1.21 | 38.4 | 8.8 |
| 2016 | 7,143 | 5,537 | 1.29 | 34.7 | 9.5 |
| 2017 | 7,688 | 7,099 | 1.08 | 14.1 | 7.3 |
| 2018 | 7,877 | 6,585 | 1.20 | 21.5 | 9.8 |
| 2019 | 7,687 | 6,693 | 1.15 | 19.5 | 7.8 |
| 2020 | 7,675 | 4,994 | 1.54 | 76.0 | 15.3 |
| Based on closing daily values for FTSE 100. Source: FactSet | |||||
Yet retail investors appeared to react calmly to the helter-skelter. According to research involving 1,000 of them carried out in December on behalf of Oxford Risk, a consultancy, only one in seven felt the need to review their investments once a day or more and half contented themselves with just a weekly review. The men – wouldn’t you know it? – were more obsessive, with 23 per cent doing a daily check. Among the women – perhaps with better things to do – only 7 per cent checked daily.
Despite this, there were signs of disorientation or maybe just naivety – 21 per cent believed the value of their investments had fallen during the Covid-19 crisis, 16 per cent thought it had risen and 48 per cent thought it was about the same. To which, the response is – it’s not rocket science to value a portfolio, so there shouldn’t be doubt about the amount unless a portfolio includes illiquid or obscure assets. Perhaps the first thing some beginners must do is load their portfolio details onto a price-checking app, of which there are umpteen. Having the means to calculate a fund’s value quickly is a useful first step away from the familiar traps into which investors fall. Most of these come under the heading of ‘behavioural finance’, the field in which Oxford Risk touts its expertise.
Behavioural finance remains a fashionable area of the dismal science, even if familiarity means it has lost the jaw-dropping originality that it brought to the 1990s. It distils down to two truths about the way people think (investors most certainly included):
● That emotion trumps rationality (though Voltaire had told us that almost 300 years ago);
● That mental ready-reckoning beats rigorous thinking (so we still think like cavemen).
In that context, Greg Davis of Oxford Risk reckons many investment decisions made by private investors are for ‘emotional comfort’ – the investment equivalent of hugging a teddy bear – and that typically costs them 3 per cent a year in returns.
It may be an equal comfort to know that institutional investors are barely less susceptible to behavioural traps, but it is still best to avoid them if possible. To do that, it helps to know which bits of faulty ready-reckoning are most common and to apply the antidote to every investment assessment. Roughly speaking, the traps come under three big headings:
● Representativeness, where we jump to the wrong conclusion because, say, we imagine an ordinary company must be great since it has superficial similarities to an attested growth stock.
● Availability, where we exaggerate the chances of something good or bad happening simply because something similar has just happened.
● Anchoring, where our thinking is stuck in one place (anchored) and we can’t adjust it to meet new circumstances.
Read up about behavioural finance (there is a reading list below), memorise the most deceptive ready-reckoners (psychologists call them ‘heuristics’) and be aware of them with every investment assessment you make. That way, you won’t have to ask where you’re heading.
Email: bearbull@ft.com
Suggested reading
Thinking Fast and Slow, Daniel Kahneman, 2011, Straus and Giroux. The ‘accessible' book on the subject by a Nobel Prize winner for economics.
Judgement under uncertainty: Heuristics and biases, ed Kahneman, Slovic and Tversky, 1982, Cambridge. An early and well-known though academic scan through ‘prospect theory’.
Advances in Behavioral Finance, ed Richard Thaler, 1993, Russell Sage. Useful collection of essays that focuses on investment-related themes.
The Winner’s Curse, Richard Thaler, 1992, Princeton University. A collection of essays that also aims for the accessible approach.
The Righteous Mind, Jonathan Haidt, 2012, Random House. Useful for its take on how thinking gets messed up with emotion.
And don’t ignore Wikipedia. The people’s encyclopaedia has lots on the subject, much of it good. Start on ‘behavioral economics’ and go where it takes you.
