When investors get off to a bad start it can be an uphill struggle to get back to even. Kyle Caldwell runs through how behavioural biases can affect investment decisions.
It has been a year many investors will want to put behind them, with most funds losing money.
Data from FE Fundinfo reflects this and out of 58 fund sectors, just six have made positive returns in 2022. The two standout performers, with returns of 18.6% and 16.7%, are commodity/natural resources and Latin America.
It has been a 12-month period that has unusually seen both equities and bonds fare badly, a consequence of higher interest rates attempting to combat inflation.
For investors in funds or investment trusts focusing on high-growth stocks and technology firms, it has been a particularly bruising year. Rising interest rates devalue the future earning expectations of growth stocks, so valuations cool and share prices re-price to reflect that.
Having enjoyed the tailwind of loose monetary policy for more than a decade in the form of record low interest rates, the more challenging backdrop for growth funds and investment trusts has not gone unnoticed by investors. In response, growth mandates have become less popular among interactive investor customers.
For longer-term investors, such as those who have been investing in growth-focused funds for five years, the sharp falls this year will have put a sizeable dent in those returns. However, the chances are that such funds will still have produced very respectable returns over those five years that are ahead of the average fund in their respective sector.
For example, Scottish Mortgage (LSE:SMT), the FTSE 100-listed investment trust that focuses on the winning stocks of tomorrow, is down 47% in 2022. However, over five years it has returned 58%, which is ahead of the average global trust return of 41.7%.
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Scottish Mortgage asks its investors to, at a minimum, judge its performance over five years. This is a prudent timescale that fund and trust investors should adopt for whichever fund they invest in to ride out the ebbs and flows that are part of investing in the stock market.
However, when investors get off to a bad start it can be an uphill struggle to get back to even, as percentage losses requires bigger percentage gains to recover. For example, a loss of 10% requires a gain of 11% to break even; a loss of 20% requires a gain of 25%; a loss of 33% requires a gain of 50%; and a loss of 50% requires a gain of 100%.
Investors who buy a fund, investment trust or individual share, and then see it plummet in a short period of time, will naturally feel panic.
What to weigh up when performance disappoints
So, how can investors decide whether to cut losses, do nothing, or buy more?
Some lessons can be drawn from behavioural finance biases, which cause investors to make irrational investment decisions based on emotion.
Inertia, which is the tendency to maintain the status quo, is one example of a behavioural bias that can affect investment decisions. Inertia is part of the “endowment effect”, where an investor places a higher value on something they own, so are therefore reluctant to sell.
Loss aversion – not wanting to incur losses - is another key behavioural bias that leads investors to hold on to an investment that has declined in value. Under loss aversion, the pain of loss is greater than the equivalent pleasure of gain.
As part of his investment process, Mick Dillon, portfolio manager of the £1.1 billion Brown Advisory Global Leaders fund, points out that in moments of stress investors need to take action by making a decision.
When a share falls notably in a short-time period, Dillion says that it is worth taking a step back and assessing whether it is “either a bargain opportunity or was a wrong decision”. Dillon carries out a “drawdown review” on companies when the share price has fallen 20% since he bought it, or has underperformed the fund’s benchmark by 20% over a 12-month period.
He explains: “Following the review, we decide to either buy more or sell. When we sell, this could reflect that something has changed, such as operationally for the business, or it could mean that we were wrong to buy. Having this review changes the mindset of the decision-making from defensive to offensive.”
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A 20% review rule is also applied by the Liontrust Global Innovation team. As part of their process, “man overboard” is applied when a share is down over 20%. This triggers an evaluation of the business.
James Dowey, co-manager of the Liontrust Global Dividend and Liontrust Global Innovation funds, said: “We do a deeper dive to assess the company. If our view on the company is unchanged and the reason for the share price fall is macro related, then we top up.”
Netflix I(NASDAQ:NFLX) is one example of a company Dowey moved to increase exposure to earlier this year, following its sharp share price slump.
Pershing Square (LSE:PSH)’s Bill Ackman, however, did the opposite. He cut his losses in Netflix in April, just three months after buying shares in the streaming firm. The losses were considerable, estimated at around $400 million.
Ackman said that he had “lost confidence in our ability to predict the company’s future prospects with a sufficient degree of certainty”. The loss of confidence stemmed from Netflix’s plans to make changes to its subscription model.
The key questions to ask yourself
Among the questions Dillon and his colleagues ask themselves during the review is whether, over the long term, drivers for the company are still in place, and whether they got it right or made a mistake on its valuation.
Dillon invests in market-leading companies providing essential products or services to their customers. Its top five holdings are Microsoft (NASDAQ:MSFT), Visa (NYSE:V), Alphabet (NASDAQ:GOOGL), Unilever (LSE:ULVR) and Deutsche Boerse (XETRA:DB1).
“We consider whether we will be wrong forever by asking ourselves whether in five years’ time the company will still be as relevant to their customers as they are today.
“Falling share prices offer the opportunity to buy more, but if it is mistake there’s no shame in cutting your losses, as those losses could become even deeper.”
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For funds and investment trusts the same sensible logic stated above applies. First, step back and try to understand why the fund is underperforming.
If it is because the region it invests in, or the investment style, is out of favour, then a period of subdued short-term performance can perhaps be forgiven.
In fact, you may view it as a good time to buy more if you think prospects for the region the fund invests in, or the types of shares it holds, will likely improve over time.
However, if it has been a favourable market backdrop for the fund and it has still notably underperformed peers, then investors need to weigh up whether to hold on in the hope that performance improves, or hit the sell button. Ultimately, it is a judgement call that only you can make.
There are two other things to consider. The first is to ask yourself why you invested in the fund or investment trust in the first place, and whether it is still fulfilling the role you intended. For example, if you bought a fund for a certain level of income, and this income is not being delivered, then you may decide to call it a day.
Second, assess whether a fund manager is sticking to their investment process. If they have made some tweaks, or more overtly changed the way they invest, then it may no longer be the same fund it was when you bought it, so it is probably time to hit the sell button.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.