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Mind over markets


Mastering the markets is as much about understanding the intricacies of our own minds as it is about analysing the numbers

Andrew Madigan, Head of Client Investment Strategy


In the world of investing, we often attribute success to a blend of sharp analytical skills and a fortuitous stroke of luck. However, there is a critical, yet often ignored factor influencing our financial decisions. This influence doesn't arise from market dynamics but is deeply embedded in our minds. It's shaped by cognitive biases that are firmly entrenched in our psyche, and these biases, even when recognised, present a significant challenge to overcome.

The financial research company Dalbar produces an annual report on investor behaviour and returns. They found that between 1991 and 2021, the average investors equity return was 7.13%, compared to the S&P 500's 10.6%.  While this disparity might seem modest, its compounding effect over time is substantial. For instance, a $100,000 invested in the average US equity fund in 1991 would have grown to an acceptable $800,000 by 2021, versus a colossal $2 million in a low-cost S&P tracker.


Dalbar's analysis determined that the number one cause for the underperformance was investor behaviour, followed by fees. Investor behaviour is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally.  The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision. (Source: 2021 DALBAR study)


For instance, a $100,000 invested in the average US equity fund in 1991 would have grown to an acceptable $800,000 by 2021, versus a colossal $2 million in a low-cost S&P tracker. Their conclusion was that a significant amount of the underperformance could be attributed to investors timing - or more accurately - failing to time the market.

Modern portfolio theory operates on the premise that investors make rational decisions. However, in reality, our emotions and biases often lead us to make irrational choices. Ironically, these lapses in rationality tend to occur precisely when calmness and level-headedness are most crucial. It was Benjamin Graham who said, "The Investors chief problem - and even his worst enemy - is likely to be himself". In tranquil market conditions, our investment decisions are largely governed by the prefrontal cortex. This area of the brain is responsible for regulating our thoughts, actions and emotions, facilitating rational decision making. In contrast, in times of crisis, the primal part of the brain known as the amygdala takes over. And the amygdala tends not to be as rational as its prefrontal cortex neighbour. Your amygdala is responsible for detecting danger and controls your 'fight or flight' response as well as emotions like fear, anger and aggression. The amygdala served an important purpose 300,000 years ago when we lived in caves, relying on primitive weapons and had to fight imminent threats like sabre-toothed tigers.


The primal response of 'fight or flight' was vital for our ancestors survival but is less suited to modern day financial dangers like volatility and recessions.

One useful way to think about these two competing portions of an investor’s psyche is through a clever analogy provided by psychologist Jonathan Haidt in his book The Righteous Mind. For Haidt, the two parts of the mind are like an emotional elephant and the rational man riding the elephant. The rational part of our mind (the rider) likes to believe it is in charge of the emotions, and in many circumstances it is. But when a crisis erupts, emotions take charge; the elephant revolts against the rider, and in this conflict the primitive brute strength of the elephant will win every time.


The challenge with our amygdala, a primal part of our brain, is that it hasn't adapted to the complexities of the 21st-century financial world. It still triggers a 'fight or flight' response to perceived financial threats, often leading investors to react excessively during bouts of market volatility. Despite the knowledge that markets generally recover over time, this instinctual response can provoke panic selling at the worst possible times - market lows.


In periods of financial distress, the amygdala vividly recalls past recessions, thereby heightening the impulse to act, frequently in a hasty manner. Typically, market dips of at least 5% occur around three times a year and declines of more than 10% are generally seen once per year. (Source: Capital Group - What past stock market declines can teach us)


Each of these events can stoke fears that this might be the start of an extended bear market, tempting investors to prematurely reduce their market exposure.


Interestingly, the frequency that an investor looks at their portfolio correlates with their performance. Investors who monitor their portfolios more frequently tend to have worse performance due to their higher likelihood of witnessing temporary losses, thereby prompting them to take action. For instance, Nassim Taleb in his book Fooled By Randomness noted that those who check daily face a 46% chance of seeing a loss, compared to a 23% chance for those who check quarterly and only 7% for those checking annually.


Investors that check their portfolio daily have 168 negative emotional experiences a year vs those that look annually have only a 1 in 14 chance of having a bad day.

I do not propose ignoring your portfolio from one year to the next but it does make it difficult to balance our long-term logical forecasts with our short-term emotional responses.


Investors grapple with not only the fear of losses but also with the fear missing out (FOMO), driven by an evolutionary trait known as 'herd mentality'. Historically, survival often hinged on staying within the group; early humans who remained together were more likely to evade threats like those pesky sabre-toothed tigers or rival tribes. This instinctive behaviour, deeply embedded in our psyche, continues to influence us today. In the context of modern finance, this herd mentality can lead investors to hurriedly join equity rallies, sometimes fuelling the formation of market bubbles. Driven by FOMO, we can find ourselves buying stocks even when they seem overvalued by all logical standards and metrics.


The behaviour of investors is also influenced by the volatility of the assets they hold. Research conducted by Morningstar revealed a direct correlation between a fund's volatility and investor behaviour. They found that investors are less likely to remain invested in, and consequently fully capture the over-cycle returns of more volatile funds. (Source: Morningstar - Mind the Gap: A report on investor returns in the U.S.)


The reason is straightforward: funds with higher volatility experience more frequent downturns, providing increased opportunities for the amygdala to override the prefrontal cortex's rational decision-making process, often leading to impulsive selling decisions.


Our emotional tendencies are hardwired into us from millions of years of evolution. While we cannot eliminate these instincts, recognising them can help mitigate their impact on our investment decisions. Our approach at Atlantic House is to offer funds with systematic and rules-based investment processes removing our amygdala's ability to interfere with performance.


Our flagship defined returns fund remains fully invested throughout the market cycle. Its deep protective barriers allow us to stay invested during market downturns, confident that historically equity markets recover back above the barriers in the long term.


Likewise on the upside, we do not chase the markets higher, we remain disciplined and focussed on improving the probability of achieving a 7-8% annual return.

This year for example, where pricing for autocalls has been very attractive, we have seized the opportunity to bolster the funds downside protection whilst simultaneously edging the targeted return up to 8.5%. This disciplined approach has contributed to cultivating a dedicated and loyal investor base, attracted by the fund's relative stability and predictability.


Year to date the volatility of the fund has been around half that of the FTSE 100. This lower volatility translates to a smoother investment experience, reducing instances where investors' amygdala might impulsively drive financial decisions.


In the end, mastering the markets is as much about understanding the intricacies of our own minds as it is about analysing the numbers; for in the world of investing, the greatest asset and the biggest liability we possess is, invariably, ourselves.

 

Past performance does not predict future performance or returns

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