The good, the bad and the ugly is, of course, the title of the stylised 1966 western starring Clint Eastwood. It is also an apt way to describe common habits of investors.
No matter whether investment markets are rising or falling or somewhere in between, an investor’s habits – good and bad – really matter.
The Journal of Portfolio Management has published an article, Bad habits and good practices, which opens with a disarmingly simple message for investors seeking sustained, long-term success: “Good investing results require both good investments and good investors”.
Its authors – professor with the University of Lausanne’s department of finance Amit Goyal and investment fund managers/investment authors Anitti Ilmanen and David Kabiller – focus on three bad investment habits, providing contrasting good investment practices.
“We have spent our careers also battling these same bad habits in ourselves,” they write, “so our prospective is fully intended as commiseration and shared experience, not as lecturing.”
Bad habit one: Chasing multi-year returns
Goyal, Ilmanen and Kabiller say this is often cited as the “premier bad habit”. It involves abandoning long-term strategic investment practices to chase multi-year winners – meaning those that have outperformed in the last few years – while dumping multi-year underperformers.
This bad habit, which has been termed as “pro-cyclic” investing, can affect an investor’s investment style, portfolio asset allocation, and their selections of individual investment assets and managed funds.
“Many investors understandably lack patience when facing years of underperformance, even if they are aware of the limited predictive ability in past performance and potentially high transition costs associated with hiring and firing,” they add.
“At worst, some investors may enter the market near its peak, despite exorbitant valuation levels, or capitulate near the bottom and miss the subsequent reversal.”
Many investors were willing to put up with a year of underperformance but “draw the line” at multi-year underperformance of, say, three to five years.
The countering good practice to this bad habit is to take a disciplined, long-term and appropriately-diversified approach with the aim of achieving well-defined investment goals. And regular counter-cyclical rebalancing of investors’ asset allocations is fundamental to keeping their investing on track.
Bad habit two: Under-diversification
Goyal, Ilmanen and Kabiller say that many investors don’t appreciate the benefits of proper diversification of asset classes and securities to spread their risks and opportunities.
Examples of under-diversification given in their paper include holding just a few stocks – in other, words, having excessively-concentrated portfolios – and having a home-bias with insufficient exposure to global markets.
They say a broad explanation is known as “narrow framing”. This is the tendency for investors to focus much of their attention on a single aspect investment or asset class rather than how it related to their overall portfolios.
Investors taking what could be described as a wider frame would tend to see a fall in the price of individual investments or an asset sector as just part of the expected movements within an appropriately-diversified portfolio. Indeed, well-diversified portfolios are designed with the intention of having some assets rising in value to counter other assets falling in value – rather than moving in lockstep.
Bad habit three: Seeking comfort while overlooking fundamentals
“Some investors seek comfort when selecting investments, whether individual securities or asset classes, instead of judging them purely on their risk/reward merits,” Goyal, Ilmanen and Kabiller say. An example of seeking comfort is to invest in the latest glamour stocks because of their image and their current popularity rather than on investment fundamentals.
And many comfort-seeking investors, for instance, pay too much for assets in their expectation for smoother, less-volatile returns.
A classic illustration of investors seeking comfort to their detriment involves following the investment herd by shifting to all-cash portfolios when the sharemarket experiences a sharp dip. And when share prices have already risen sharply, investors attempt to gain comfort in the crowd by following the herd back into the market.
A key take-away message for investors is that for every bad habit, as the authors of this paper write, there is good practice. Astute investors not only know what bad habits to avoid but develop strategies or practices to avoid them.
12 December 2016