The psychology of investing is fascinating. Not only is our decision-making typically influenced by biased risk/return metrics, but the outcomes are also super-charged with emotion.
This is precisely because outcomes involve our own money, i.e. they represent financial gain (or loss).
Financial gain/loss is a relative measure. Although we talk about absolute gains, such as “I just made $60k” or “my salary increase was 8.2%”, what really matters is how these numbers stack up
relative to everyone else. If the average increase was 10%, we would be chastened by our poor results. On the other hand, we would be chuffed if everyone else received 3%.
A classic US study in this area, conducted in 1995, asked respondents about relative wealth status. In which situation would they rather live? Either:
A. Earn $50,000 a year where others earn $25,000; or
B. Earn $100,000 a year but where others earn $200,000.
What do you think the survey showed? More importantly, which would you choose? Would you rather feel relatively wealthy? Or be better off in absolute terms but feel relatively poor?
Although the individual, and everyone else, would be better off under Situation B, 56% of respondents in the actual study selected Situation A. This is not a landslide result but does indicate an important preference towards avoiding relative loss. You can read the original study here (https://www.albany.edu/~gs149266/Solnick%20&%20Hemenway%20(1998)%20-%20Positional%20concerns.pdf). Unsurprisingly, there are applications of these principles within investing.
Consider the following graph. It shows returns for two different portfolio series over the past 20 years. They ultimately arrive at the same point – but would you rather hold Series A or Series B?
The series you prefer says a lot about you and your own psychology. Beyond just looking at the shape of the lines, it is important to note that:
- by March 2019, these series both end at the same place.
- over the 20-year period, each beats the other fairly evenly on an annual basis: Series A is in the lead for 7 consecutive years 2012-2018 and Series B for 6 years 2000-2005.
- on a monthly basis, the difference is more stark. Series A out-performs its counterpart for 135 of the total 230 months. By contrast, Series B out-performs for only 95 months.
- Do you like roller-coasters? Series A demonstrates significantly higher volatility. From 2007-2009, Series A suffered a 42% loss of capital over the worst 18-month period. By contrast, over the same period Series B lost only 17.1%.
- Do you experience FOMO? At one point in time (Oct 2007), Series A was 38% ahead of Series B. However, only 12 months later (Oct 2008), Series A had fallen significantly and lagged behind Series B by 9.5%. In just one year, Series B managed to overtake Series A and was nearly 10% ahead.
Some investors would select Series A without hesitation because of its potential to out-perform. These investors would likely state that they could time the market and get in and out, allowing them to lock in gains and avoid losses. Unfortunately, as we have previously discussed here in The Insider, it is exceedingly difficult to consistently time the market correctly. For this reason, other investors would choose to embrace Series B, particularly across a long-term time horizon. It delivers much the same results but without any of the emotional upheaval caused by volatility.
Series A, as it happens, is the JSE All-Share Index, shown here without any adjustments of any kind. Investing in a passive tracker would have generated these upward but jumpy returns. Series B is a synthetic, cushioned index that tracks the ALSI and generates 60% of upward movements but only 40% of losses. This provides a smoothed return while achieving the same through-the-cycle returns.
To date, it has been difficult within South Africa to find a fund like Series B. Methodical manages a private strategy which, since 2016, has been targeting just this approach: delivering exposure to domestic equity market but with some downside cushioning. This strategy has recently been opened for public distribution and will, we hope, fill a market gap by providing a solution for investors that prefer Series B style return profiles.
This isn’t just a question of providing fund solutions, however. This strategy gets to the heart of future expectations. Yes, the broad equity markets have delivered 10 years of strong (and increasingly bumpy) returns. Looking forward, though, are there many investors who believe we will have another 10 years of strong growth? Perhaps that is why many fund managers are seeing capital outflows, as nervous investors re-allocate funds towards cash or overseas. It is our hope that the Methodical Equity Preserver Prescient Fund gives investors an option to remain invested in SA equities in the years ahead.
Disclaimer: Collective Investment Schemes in Securities (“CIS”) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CIS’s are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. There is no guarantee in respect of capital or returns in a portfolio. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. CIS prices are calculated on a net asset basis, which is the total value of all the assets in the portfolio including any income accruals and less any permissible deductions (brokerage, STT, VAT, auditor’s fees, bank charges, trustee and custodian fees and the annual management fee) from the portfolio divided by the number of participatory interests (units) in issue. Forward pricing is used. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). Methodical Investment Management (Pty) Ltd, Registration number: 2010/011976/07 is an authorised Financial Services Provider (FSP44480) under the Financial Advisory and Intermediary Services Act (No.37 of 2002). For any additional information such as fund prices, brochures and application forms please go to www.methodical.co.za.Back to Literature index