When synapses fire and portfolios crash

With the ASX200 hitting 11-month highs, Brexit looks like it was a buying opportunity. John Addis explains why most investors missed it.

Along with the entire Italian banking system, European banking giant Deutsche is skirting trouble. The question from the floor at last Wednesday’s Melbourne seminar wasn’t therefore a complete surprise: ‘What do you think is the percentage chance of Deutsche Bank causing a full scale European banking crisis?’

I’ve known research director James Carlisle – the person to whom the question was addressed – for many years and not once have I heard him forecast anything except his lunch. In fact, James has a disarming ability to make all sides of an argument at pretty much the same time. His answer was almost instant: ‘43’.

We all know the folly of prediction and yet, faced with a complex, uncertain world, it retains a comforting allure, a point well understood by business journalists. It’s perfectly acceptable to say ‘I don’t know’ on Family Feud but it won’t get you onto the back page of the Financial Review. Market commentators can’t possibly know the future and still we grasp at the hope they might. It’s a charade, of course, but one with willing participants (except James, whose precise, ironic answer was a refutation of it).

Key Points

  • We forecast disaster more frequently than it occurs

  • Availability and confirmation bias worsen this tendency

  • Skills to overcome our brains shortcoming

This is not to criticise the questioner, who had made the thoughtful step from dualistic to probabilistic thinking. But whatever figure James’s interlocutor eventually settled on, research indicates it will likely be too high. Investors tend to greatly overstate the risk of major financial events. This is a crucial point worth understanding: if the threat of Brexit, a potential European break-up, a China crash, a collapsing Australian property market or a potential military conflict in the South China Sea is making you hesitant or scared, you could be on the verge of a costly mistake.

Jumping at shadows

The Crash Beliefs From Investor Surveys is a longitudinal study conducted by Nobel Laureate Robert Schiller (he of the Case-Schiller Index for US housing), William Goestzmann of Yale and Dasol Kim of Weatherhead School of Management. Running since 1989, one survey question asks respondents to estimate the probability of a severe crash over the ensuing six months, a crash being a drop in the US sharemarket akin to Black Monday (19 October 1987), when the Dow Jones Industrial Average (DJIA) fell 22.6% and 28 October 1929 when it fell 12.8%.

Despite there being just two such events in the 20th Century, over the last three decades respondents believed there was, on average, a 19% risk of a similar fall in the next six months. Perhaps as a reflection of the times, the most recent survey put the figure at 22.2%. What is the actual probability? An analysis of the historical data suggests the real probability of such a major sell-off in any six-month period is just 1.7%.

But it isn’t just 1-in-5 investors constantly forecasting imminent disaster. According to The New York Times, after Black Monday 33 economists gathered in Washington, DC, to warn that ‘the next few years could be the most troubled since the 1930s’. But economic growth actually rose in 1987 and 1988 while the DJIA regained its pre-crash high in early 1989. It isn’t just investors that catastrophise.

Constantly forecasting disaster has a profound effect on portfolio performance. The response to Brexit is a case in point. The Australian reports that online broker CommSec usually processes 80,000 transactions per day. On June 24, the day after Brexit, it handled almost 200,000 trades while competitor Nabtrade experienced a 250% increase in daily turnover. In aggregate, the ASX recorded twice its usual number of transactions. The All Ordinaries Index fell 3.1% on the day.

At either end of every transaction is a buyer and a seller. The mechanism by which one is matched with the other is the price. When the overall market falls on higher volumes, prices must be falling to match buyers with sellers. Let’s try and inhabit the minds of both groups to see which is most likely to exhibit the behaviours of successful investors.

Painful memories

For many investors, including yours truly, the global financial crisis remains a fresh and painful memory. That means we’re more likely to fall victim to availability bias, the tendency to use easily recalled events to estimate the probability of similar future events. The human tendency to forecast disaster is amplified by this bias. And once we have new ‘evidence’ that appears to support our existing beliefs we tend to use it as confirmation of them (see confirmation bias).

Imagine what the initial thoughts of the average investor – one that recalls the collapse of the global banking system in 2008 – might be on the morning after Brexit? Markets everywhere have crashed. The NASDAQ fell 4.12% and the DJIA experienced its 9th largest one day fall ever. Bank shares are tumbling. Barclays fell 20% and HSBC and US bank Citigroup 9%. Immediately, there’s talk of a European Union break-up. A few days later UK banks announce job losses, talk of a property crash increases and some UK property funds ban withdrawals. Newspaper headlines are terrifying.

Against this backdrop, selling out doesn’t seem rash and impetuous but sensible and rational. After all, investors that sold down their portfolio when the Federal Reserve Bank of New York provided emergency funding to Bear Stearns in March 2008 would have saved themselves a world of pain. After a strong coffee, they open their CommSec online broking account and start sifting through the stocks to sell first.

Taking advantage

What about potential buyers, hoping to take advantage of falling share prices? Well, they’re aware that there is a risk that Brexit is a forerunner of another GFC-style event. But they also know of the brain’s tendency to constantly overestimate the chance of disaster, which is why they find it easier to ‘buy on the bad news and sell on the good’.

They’re also aware that availability and confirmation bias exacerbate this tendency and that highly charged news headlines feed an emotional response to financial threats. As Johnson and Taversky found in 1983, ‘judgments about risk … seldom occur in an emotionally neutral context’ and that reporting of negative events has an adverse impact on the accuracy of probability assessments. After weighing things up and listening to the doom-laden news headlines, they fire up their computers and go bargain hunting.

You can probably guess which camp Intelligent Investor fell into. On 26 June (a Sunday, no less) we published our Brexit Buy list, which presaged at least four upgrades, including National Australia Bank, stating that ‘there are a bunch of opportunities currently on our Buy List that are now looking even better value’.

Only time will tell who got the right end of the Brexit selldown, but with the ASX 200 hitting 11-month highs, those taking the tougher course are ahead at the moment. Over the long term shares have tended to be a great place to invest, and the spectre of a crisis has often provided an opportunity to get a head start.

Successful value investing is easy to understand and hard to do precisely because it asks that we overcome our psychological biases and act rationally in highly charged, emotional situations. Most investors can’t manage that, which is good news for those that can. It isn’t easy but once you’ve learnt how your brain is wired up to undermine portfolio performance there are techniques to overcome that tendency (see How to make better decisions Part 1 and part 2).

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