Investing successfully isn’t easy. It’s certainly difficult for personal investors and - perhaps surprisingly - it’s also difficult for investment professionals.

Three main factors make investing difficult:

• Prices already reflect publicly available information;
• There is no crystal ball (you can’t predict the future);
• We are not rational.
  
  

It’s Already in the Price

Company X announces a record profit, and, as you’d expect, Company X’s share price immediately… stays exactly the same.

But hang on, shouldn’t the share price go up? Company X just announced a record profit for goodness sake!

No, and here’s why: the market already anticipated this record profit months ago. It’s already in the price.

Now try this: Company Y announces a record profit… and Company Y’s share price promptly drops. Seems counter-intuitive doesn’t it? Profit up should mean share price up, right?

No. Not if the market was expecting a bigger profit. Not if the market had already factored in that bigger anticipated profit into Company Y’s share price months ago. Not if a bigger profit was already in the price.

Financial markets have thousands of well-informed investors. You only need to observe the daily news reports and see how quickly information is reflected in share prices. As a well-known market pundit said “Everything I know is known by the market and worked in to the market”.

A current fashion amongst investors is to invest in Energy companies. But by the time the average investor has read about a favoured stock or industry, the market has already priced in those higher profit expectations. As seen from the table below, current investor sentiment is already reflected in the current prices of certain securities and of whole sectors.

The table below shows the average PE ratio in May 2008 of the main sectors of the Australian stock market. The PE ratio shows you how much (Price) you pay for a dollar of profit (Earnings):

At a glance you can see how a dollar of profit from an Energy company is much more expensive than from a Finance company. You only have to pay $10 for a dollar of profit from a bank but you need to pay $28 for a dollar of profit from an Energy company. These industries may have growth levels that justify these higher prices as you may get more than one dollar from the Energy company next year, but you may not, therefore making the investments more risky.

The main point is that the market is already well informed, and the prices of companies - and even whole sectors - already reflect investor reactions to recent information, making the investment process more difficult than it at first appears.

Do you know what profits are expected? Do you get the announcements as quickly as others investors? Does it matter anyway? It’s probably already in the price.

There’s No Crystal Ball

Here’s a statement that your brain will readily accept as being logical and true, perhaps even self-evident:

And it is true. Totally and absolutely. The problem is, although your brain accepts this truth, your gut believes otherwise. Your gut instinct tells you the opposite is true. It keeps nagging at you, telling you that past performance does indicate future returns, that past performance is the closest thing there is to a crystal ball.

Unfortunately, despite the fact that we all want to believe it exists, there’s no crystal ball.

The amount of market information available to investors today is staggering. Unfortunately, it’s mostly historical information, and money is not made on what has happened but rather what will happen.
With no crystal ball available, the only alternative is forecasting, otherwise known as speculation. And it has proven to be a poor basis for investment decisions. Too much reliance on forecasting can lead to poor investment returns.

Question: How many of these market realities were correctly forecast?

• Private Equity (http://en.wikipedia.org/wiki/Private_equity) investing being popular in early 2007 then disappearing in mid 2007.


• The entire Listed Property Sector dropping by more than 30% since in the six months from November 2007 • Interest rates going up.


• The now infamous ‘Sub-Prime Crisis’ and follow on ‘Credit Crunch’. (please get rid of the space between these points)


• Stock Lending and Opes Prime.


• Widely known names including ABC Learning, Centro Property, MFS, Allco and Babcock and Brown being dumped by the market.


• Sovereign Funds.


• Largest bailout of financial institutions in history by central banks.


• Energy Crisis, with oil prices highlighted.

Answer: Not many.

Why? Because there’s no crystal ball.

We are Not Rational

Behavioural Finance is a relatively new field of science. It provides considerable evidence of common practices that highlight the irrational behaviour of investors specifically, and people generally.

Set out below are some identified patterns of behaviour that result in decisions that negatively impact on a portfolio’s performance.

Loss Aversion

Many investors hang on to losing stocks and sell out of winning stocks. The pain of losing money is far greater than the pleasure of making money

Overconfidence (“Don’t confuse a bull market with genius.” Source – KK)

Investors over-estimate their knowledge and under-estimate their risk. When the market is rising, investors attribute profit to their abilities, rather than a booming economy and stock market.

Self-Attribution Bias

Investors attribute good outcomes to skill and bad outcomes to misfortune. Good outcomes increase belief in investors’ ability, leading them to take more risks. Bad outcomes are seen as misfortune and not the fault of the investor.

Availability Bias

The more recent and prominent the information, the more importance an investor attaches to it. Investors often believe companies covered by the media deserve special attention. However, distinguishing between noise and information is not always easy. Indeed, research has shown that, on average, companies that are often in the media actually perform worse than the market average.

And a few more common behaviours we’ve observed:

• People remember the stocks that did well, while not closely considering the returns of the whole portfolio, including various loss makers.
  
  
• Investors become impatient with stocks that have not yet performed well, so they sell and then buy another stock, resulting in higher turnover and higher costs.
  
  
• Some personal investors think they can identify when the market has peaked and when it has reached bottom, when professionals find this nearly impossible.
  
  
• Former executives hang on to large share holdings of the company they once worked for, and thereby take on considerable unnecessary risk.
  
  
• People have more difficulty in selling rather than buying stocks.

Since you’re human, you and your advisors are also vulnerable to these human foibles and biases when making important investment decisions.

But now there’s a rational way to deal with this human tendency towards irrationality: ask PortfoliOK to perform an evaluation of your (and your advisors’) past investment behaviour. Get started now.

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