InvestmentsDec 4 2013

Illogical behaviour

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We can see this phenomenon in London house prices at the moment. Because house price performance has been so strong, people have the confidence to borrow more and more money, further encouraged by government subsidies. Yet in rural areas prices have not recovered from the fall caused by the credit crunch and in many areas have actually stagnated since then.

Of course, the reasons for this illogical behaviour towards investments are our two-old friends: fear and greed. Although our heads tell us that we should be buying shares after a crash, our hearts are too fearful and we think we might lose money. The mirror image of this happens in a bull market; we know that the shares are a bit expensive, but feel optimistic and greedy, so we pay up in the hope of making more money.

Yet investment history shows us that a big driver of investment success is the original price paid for the share. Old-fashioned stockbrokers often took a fairly simplistic view of valuation if they liked the company; if the share P/E ratio was in the low teens, buy and sell if it got near 20. If it dropped into single figures, it was a once-in-a-lifetime buying opportunity. However, despite the simplicity of this strategy, very few investors seem able to overcome their emotions and follow this advice.

One reason for this is that when the buying opportunity comes, it is often combined with extremely gloomy coverage by the financial commentators. Economists in particular focus too much on small changes in gross domestic product and often forget that stock markets do not reflect short-term economic performance. They are surprised when markets rise strongly as investors start to predict better times. It could be argued that many economists admit they have a poor record at predicting market trends, yet they are still read avidly by investors. So it seems very brave to buy shares in these times, although it is nearly always the right thing to do. Similarly, it is difficult to force oneself to sell when everything looks good and the market is going up.

If investors miss the big increases in markets, which you typically get at the beginning of a bull run, because they are too cautious, they will be playing catch up for a long time. Then there is the danger of delaying too long hoping for a decline and another opportunity to buy. Worst of all they will be ‘sucked in’ just before the market begins to fall, when they should be thinking of selling.

One of the most difficult things to force oneself to do is to sell when the market is expensive. For one thing, the timing is very difficult and it can stay expensive for a very long time and get even more expensive. Tax can also be an issue, as we tend not to want to trigger a capital gain. Many wealthy families avoid the latter problem by keeping their risk assets inside a privately controlled open-ended investment company, as changes within the fund will not trigger tax, although sales of shares in the fund itself will.

To summarise, there are just a few times, such as crashes or evident bubbles, when it is pretty evident that shares become very cheap or very expensive and investors should ignore the noise from commentators and act confidently. Most of the time, however, it is probably better to set a target asset allocation and use rebalancing to help your portfolio’s return, without attempting to time markets.

William Drake is co-founder and chief executive of Lord North Street Private Investment Office.