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    Behavioural Finance

    With the turmoil in markets in the second week of August, both locally and abroad, one has to ask the question why common sense and rationality often does not prevail in markets.

    The Efficient Markets Hypothesis (EMH) states that market prices reflect all available information, and that it is impossible to outperform the market consistently on a risk-adjusted basis. Whenever new information becomes available in the public domain, EMH proposes that a share’s price will quickly adjust to a new level implied by the underlying value of the share, given this new information. However, it is clear that as soon as humans and financial markets start interacting, EMH often does not hold at all!

    The field of behavioural finance tries to examine and explain why we sometimes make irrational and incorrect choices when faced with financial decisions. Some of the more interesting observations in this field are:

    Anchoring and Adjustment: When required to value a certain asset, most people start with an initial estimate and then adjust their answer away from this anchor. A good example may be a car advertised in the local newspaper for a certain amount, or “nearest cash offer”. The advertised price will immediately influence buyers’ valuation of the car, even though the anchor may be ridiculously high! In the investment environment it is prudent to distance oneself from unrealistic anchors observed in the market. Valuations are often driven up by fellow investors’ exuberance, and prices start to deviate too far from the underlying values. When investing for value as opposed to growth, be certain that the fundamentals of the proposed investment are sound!

    Framing: In a past study an audience were asked either how “long” or how “short” the movie they saw was. The average answer to the first question was 2 hours and ten minutes, and to the second question only 1 hour and 40 minutes! In the financial sphere questions can often be framed either in terms of gains or losses, and the specific wording can have a big impact on the decision made. We feel the pain of a loss more intensely than the joy of a gain, and as a result we may be more risk-seeking when faced with potential losses in order to try and avoid the pain.

    Status Quo bias: People often have a preference for maintaining their current situation and avoiding possible changes, despite all evidence and advice pointing in a different direction. An example might be an investor being invested in a specific fund for a very long time, and then being too foolhardy or sluggish to pull out when things take a turn for the worse.

    Confirmation bias: Many investors start off with a certain view on a specific asset class or fund, and then hunt for evidence to support that view. Evidence not supporting the original view will merely be dismissed or not valued highly enough. With the wealth of data, ratios, and performance analysis tools out there, it is often said that almost any view can be supported by just discovering the right statistics. Always make sure that an asset’s value is supported by healthy fundamentals when faced with statistics and past figures that paint a very rosy picture.

    At Seed we realise that investors driving markets are often irrational, and the challenge is to focus on our established methods of asset class valuations and manager research throughout the market cycle. The human factor will always be present in our decision-making process, but being aware of the factors mentioned above enables us to constantly improve our investment processes and research.

    To sign up to Seed's newsletter (which includes weekly investment reports, fund fact sheets, market overviews, and more) click here and enter your details. For regular updates on investment and economic news visit our Facebook Fan Page by clicking here and 'Liking' our page.

    Kind regards,

    Cor van Deventer
    021 9144 966

    Permalink2011-08-30, 14:46:20, by Mike Email , Leave a comment

    Circle of Competence

    As investors, it is important that we invest within our circle of competence. Purely purchasing an asset, be it a share, bond, property, commodity, etc, based on a hunch or trend is a sure way to destroy capital over time. There is no doubt that this type of purchase (note that this would not be regarded as an investment) can, and will, at times produce spectacular returns, but if repeated can, and will, also lead to spectacular losses. We therefore often refer to these purchases as speculating.

    Building an investment circle of competence requires a significant number of man hours of diligent research and analysis. Someone entering the industry and starting a small operation will no doubt have a smaller circle of competence than a company with a 50 year track record and 100 investment professionals. A small circle of competence does not preclude an investor for great performance, but does limit the areas in which the investor can invest with confidence. Over time an investor will be able to expand their areas of expertise, with successful investors being the ones that don’t attempt to invest outside of their circle or grow their circle too quickly.

    Warren Buffett is famous for saying that Berkshire Hathaway constantly focuses on staying within its circle of competence. He is generally regarded as the most successful investor of all time, but famously passed up on investing in TMT (Technology, Media, and Telecommunications) companies. In the late 1990’s he was widely criticised as not being in touch with the ‘new world’, but was adamant that he’d continue to focus on investing in what he knew. Orbis, Allan Gray’s sister company investing globally, also avoided TMT shares in the 1990’s.

    Warren Buffett, through Berkshire Hathaway, and Orbis were happy to ‘stick to their knitting’ and carry on investing within their circle of competence. They both have outstanding long term track records but went through extremely tough relative periods at the end of the 1990’s. There were, no doubt, some managers who were able to profit handsomely during the TMT boom and bubble but Buffett and Orbis were brave enough to admit that they didn’t understand the valuation of TMT companies and that they were therefore not going to invest into them, a move that was vindicated in the early part of the 21st Century. Interestingly, Orbis currently has a large holding in technology shares. They have clearly worked hard on developing the right skills to be confident in their ability to value technology companies.

    The fear of ‘missing out’ is often the main reason that investors stray from their circle of competence. Seeing others profiting from strategies that you are not entirely familiar with can be frustrating, but changing your strategy to an unknown one with is a certain way to generate disappointing returns.

    At Seed we are constantly working on slowly expanding our circle of competence. The expertise developed over years of asset class valuation and manager research has stood us in good stead in managing our multi-managed portfolios. The evolution of our skills has resulted in the development of the products and services that we offer to our clients. Understanding our process inside and out is key to sticking the course when things get tough.

    To sign up to Seed's newsletter (which includes weekly investment reports, fund fact sheets, market overviews, and more) click here and enter your details. For regular updates on investment and economic news visit our Facebook Fan Page by clicking here and 'Liking' our page.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-08-23, 15:42:51, by Mike Email , Leave a comment