Stock markets have been strangely calm in 2017, but this quiet won’t last forever – it never does. What will you do when markets eventually head south? Will you rejig your portfolio and give it a more defensive hue? Will you make a dash for cash or opt for the safety of bonds? Or will you do nothing at all?
Consider another scenario, one from the world of professional football. A goalkeeper is about to face a penalty. Should he dive to the left or right just before the ball is struck, or should he stand still in the hope the penalty-taker aims towards the middle of the goal?
Best bet
According to a 2007 Israeli study of 286 penalty kicks, almost 29 per cent of penalties are shot down the middle, similar to the amount placed to the left or right. It’s easier to save such penalties, so the goalkeeper’s best bet is to stand still – doing so would give him a 33 per cent chance of saving the penalty, compared to 14 per cent on the left and 13 per cent on the right.
However, goalkeepers almost always dive to the left or right, staying in the centre on only 6 per cent of occasions.
Why are goalkeepers making such lousy choices? The answer, said the researchers, is that it’s normal to jump to the left or right. If the goalkeeper dives to the left or right and a goal is scored, he can say he did his best. If he doesn’t move and a goal is scored, he feels worse as it looks like he didn’t do anything to stop the goal.
‘Bias for action’
There is a “bias for action”, a bias that can affect people in many different domains – including, the authors cautioned, in the world of investment.
Now, there are many reasons why investors should resist the urge towards action. In the wake of the fall of Lehman Brothers in October 2008, Warren Buffett advised investors to not panic and to remember the Dow Jones index climbed from 66 to 11,497 in the 20th century, despite having to endure two world wars, the Depression, and a "dozen or so recessions and financial panics".
Those who heeded Buffett’s call have done well. Including dividends, stocks have since tripled.
The same point is often made by Vanguard founder John Bogle. Investors will likely experience "about one so-called market crisis a year", he said, following Britain's shock Brexit vote.
“Do you really want to get out of your long-term investments – and then try to jump back in at the right moment – say, 30 to 40 times in the next three or four decades?”
Bogle’s anti-action philosophy – “don’t do something; just stand there” – echoes Buffett’s description of his investment process as one of “benign neglect, bordering on sloth”.
Hyperactive fund managers
Fund managers tend not to heed this advice. In the UK, a Financial Services Authority study found the average manager turned over about four-fifths of his portfolio annually. This level of "hyperactivity", said UK fund manager Terry Smith in 2013, results in increased trading costs of around 1.4 percentage points annually.
A US study investigating the performance of 1,758 funds found that those with the lowest turnover and trading costs outperformed funds with the highest trading costs by 1.78 percentage points annually.
Often, fund managers have little choice but to take action, even if sitting tight may be a better option. Value investing legend Seth Klarman points out that a fund manager cannot retain a long-term focus if his fund is down 20 per cent and he is facing redemptions requests from unnerved investors.
Ordinary investors are blessed in that no one is analysing their quarterly performance or telling them to engage in window-dressing (a practice whereby fund managers buy recent winners and sell recent losers before the quarter ends, thereby giving the impression their performance was better than it really was). That’s why, says Klarman, the “single greatest edge an investor can have is a long-term orientation”.
Unfortunately, equity market institutions are designed to "aggravate" investors' bias towards action instead of helping them resist it, according to British economist John Kay. The action bias "is found at almost every point in the equity investment chain", he wrote in the 2012 Kay Review into short-termism in UK markets. Traders' returns are closely related to their trading volumes; analysts must produce narratives that generate "buy" or "sell" recommendations; bankers and advisers derive earnings from transactions.
Strength of character
The reality, Kay noted, was that “many people in the financial services industry who claim to be in the business of providing advice are in fact in the business of making sales”. Furthermore, “it requires strength of character to advise a client to do nothing, and few clients will pay much for that advice”.
While the financial services industry may aggravate people’s bias towards action, many investors have an inbuilt desire for action.
"Not only do we desire quick results, but we love to be seen as doing something", writes investment strategist James Montier in his Little Book of Behavioral Investing, where he cautions against the "perils of ADHD investing". Montier cites a revealing study, Nonspeculative Bubbles in Experimental Asset Markets.
It’s commonly assumed bubbles are driven by the “greater fool” theory – the fact you can profit by buying an overpriced asset and then quickly selling it on to another eager purchaser. In the study, however, participants played a game whereby they could buy shares but were prohibited from reselling them. Even though the players could not profit from their transactions, frenzied trading nevertheless ensued, resulting in bubbles and crashes.
The “bias to action” was clear, noted Montier; participants “were simply trading out of boredom”.
Especially obvious
Research shows this bias is especially obvious after a loss has been experienced. In one psychological study, participants were presented with a statement regarding two football coaches whose teams had lost 4–0 the previous week. The following week, one coach makes three changes to his team, while the other fields an unchanged line-up. Both teams lose 3–0. Which coach will feel more regret? A large majority pick the coach who made no changes.
The investment parallels are obvious. Most of us are inclined to leave well enough alone in a benign market. When the going gets tough, however, the urge towards action takes over – the impulse that you must make a change, even though you’re not really sure what that change should be.
The problem is there is "nothing so terrible as activity without insight", to borrow from Goethe. That's confirmed by a story related by money manager James O'Shaughnessy regarding an internal review conducted by US fund giant Fidelity into its top-performing accounts.
The best performers, it turned out, were accidental winners – they were the people who had forgotten they had an account.
