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Investor Psychology

Tue, 20 October 2015 17:58
by Mr. T
Editorial

The rise of behavioural finance has delivered useful tools for analysts and investment managers.

A deeper understanding of how psychology affects investing — and the biases which may come into play — can help address these weaknesses.

When I was doing my thesis at college, I chose this field mainly because if you look at markets, most are influenced by individuals. The forex market, for example, is so irrational that you have to be able to understand trend analysis before you start. George Soros made a huge fortune from foreign currency - mainly because people think what he buys is gold, and by that aiding him.

But one of the oldest and most fundamental human weaknesses — the love of a good story — is often overlooked. Stories offer an appealing wrapper for a mixture of fact and fiction. Disentangling which is the challenge.

This weakness may be at the root of the long-running emotional attachment to the emerging markets’ story. Investors love stories. Narratives can help to make sense of facts and figures. Stories can convey meaning by juxtaposing often unrelated information, and they offer hope. But not all stories have happy endings.

The latest chapter of the emerging markets’ growth story has come as a nasty surprise to many, and there may be worse to come. Remember, it’s only in movies where we have happy endings always. This is also changing.

I notice that when the Nigerian movies start, an actor will die, but will be resurrected at the end of the movie. Real stories might end up with even the bad guy dying.

Narratives have intrinsic appeal, and are told by companies to their shareholders, by investors to clients and even by politicians to voters. People want to believe. Growth always sounds good, and the concept of lifting poorer parts of the globe onto better living standards seems like impact investing.

Advocates of the BRICS and emerging markets talk more about belief and a brighter future than they do about hard numbers. Their faith is not so easily unsettled by mere facts. We need to look at reality, and start living reality.

Unfortunately, studies suggest there is not much of a link between market returns and economic growth — at least not any relationship of investment value.

Psychology comes into play when the representative bias encourages the belief that a growing economy must mean rising stock markets.

Yet, even the idea that revenue gains must translate into profit growth is questionable.

Developing economies are turbulent environments, with some unique risks to businesses. And that is before political instability, currencies and credit are taken into account.

Even though forecasts are fraught with uncertainty, investors can learn from history. The long-term economic record in China, Argentina and India shows that development is not a straight-line exercise.

Emerging economies can spend decades dropping down the rankings, often wiping out equity investors. Do we sit down and learn from our mistakes? I doubt - do we learn from peers like China? Maybe.

The record shows previous regional crises — in Asia and Latin America — but rarely a broad-based pattern hitting all emerging economies.

The current crisis looks different. It has developed slowly, catching many investors unaware. No single economy is overheated, nor is there any clear external shock.

A sharp fall might have jolted investors’ faith in emerging markets, and thus created a fresh narrative about panic and rebound.

Instead, economic growth has gradually deflated, along with a slowing of world trade and a fall in commodity prices.

Were it simply a bubble being pricked — an asset overvaluation — investors might have a better understanding of where the floor lay. Instead, it is a creeping crisis of anaemic growth, with no clear solution.

Should the BRICS defend currencies which may really be overvalued? Is the South African Rand playing the market or it’s being pushed?

And, does competitive devaluation offer any real solution to failures of productivity or infrastructural investment? Many of these developing nations have failed to create sustainable value-add, a problem highlighted but not caused by falling commodity prices.

The one continuing competitive strength which emerging markets had in common was the ability of their governments and corporations to borrow cheap US dollars. Indeed, this has arguably been the biggest single factor driving the dream.

In recent years, there has been little limit to leverage, and almost no cost. Now, the world is no longer awash with dollar liquidity, and those dollars look increasingly expensive to repay.

Disentangling narratives is difficult. The simple act of aligning arguments with varying degrees of credibility can create a whole which seems to make perfect sense.

Emotional attachment to such a narrative can then make it difficult to interpret new facts. The potential for political risk to emerge from current economic problems is scarcely recognised in most sell-side research.

Growth and diversification have been argued for so long that many investors now find it difficult to retain objectivity.

Economic history offers a useful lens with which to view narratives. Comparing what once seemed persuasive with the eventual outcome can be a useful reality check. The past can help give context for the excitement of the new. Investors need a new narrative on emerging markets — preferably a non-fiction one.

The economies have potential for future growth, but investors need to analyse the hard facts of what this means for stocks. More thought must be given to politics, deregulation, productivity and realistic infrastructural investments.

Wishing for a rise in living standards around the world is laudable, but equity investors must combine this with objective analysis.