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2022 Outlook: A New World Order

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As we enter the second quarter of 2022, we see some longer run trends which are here to stay. Can it still be said that we live in a globalized world? Or rather a “multi-polar” world with more centres of power?

 

It is likely that the world order has changed for good, in some respects for worse, in some for better.  Some of the longer run trends we see that need to be incorporated in positioning portfolios for decent returns over the coming decade are:

  • The change from globalization to increased fragmentation and the emergence of a “multi-polar” world has been accelerated by this war. This will have implications for changes in the global supply chain and an impact on inflation. There will be two or more centres of power each of which will try to control the flow of information, technical know-how, and other vital supplies within its own sphere of influence.  How will China and India position themselves within this multi-polar world?  And will current US-European unity survive differing economic needs?
  • The “Peace Dividend” which has kept risk premiums low since the end of the cold war, is now probably a thing of the past – geopolitical risk is back in the equation. This also means there will be an increase in defence spending, including on cybersecurity.  Germany has already pledged it will increase its contribution to NATO to 2% of GDP, dramatically reversing decades of post-cold war foreign policy.
  • The global financial system, with the USD as the leading currency, has been “weaponized” in this war as never before. In the past, smaller economies such as Iran and North Korea have had their Central Banks sanctioned, but never an economy as large as Russia.  What will be the (unintended) consequences of this?  An increase in the use of Crypto currencies?  The growth of alternative financial systems, away from the dollar-centric one?  China already has its own SWIFT-type system, and both China and India have allowed payments in Chinese currency for oil and commodities, whilst remaining careful not to violate blatantly Western sanctions.
  • Clean Energy stocks have done well in recent weeks; in particular the EU will be ramping up its development of clean energy adoption in order to wean itself off Russian oil and gas. This accelerated adoption of alternatives will cost money and cause “greenflation” i.e. it will add to inflation in the short term, but will be beneficial to both the climate and the economy in the longer term.
  • In the current “value stock vs growth stock” debate, it is important to remember that, once value stocks have regained a certain valuation-multiple relative to growth stocks, the underlying current investment climate is one where true growth will be increasingly scarce and pricing power is therefore of vital importance to profit margins. The type of stocks to which we want to maintain exposure will be quality growth stocks with solid cash flows and pricing power.

We are mindful of incorporating the above factors in portfolio strategies.

Furthermore:

  • We retain a “neutral” exposure to stocks. The regional allocation of Equity portfolios is also neutral; higher risk premiums on offer in European and Emerging Markets stocks are offset by US markets’ “safe haven” appeal.
  • We remain underweight government bonds as interest rates are rising. Global broad based government bond indices are down 7% since the start of the year, failing to perform their traditional hedging role during a period of geopolitical upheaval.
  • While we underweight bonds, we remain overweight “alternatives” which now include gold and commodities as an additional inflation hedge.

As always, please do not hesitate to contact us if you have any questions or comments, about the contents of this report or your portfolio in general.  We hope you are safe, and well, and managing to keep your hope alive in these turbulent times.

To read the complete Manager’s Report, please visit our client login area or contact us.

Date: 5 April 2022

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Manager’s Report published on 31 March 2022

Contact: enquiry@isgam.ch

This document is prepared for educational and informational purposes ONLY, by ISGAM AG. Please click here for the important information. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. The information provided is not to be treated as advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. Past performance is not a reliable indicator of future performance.

Economic Insight Of The Week: The Great Supply Chain Disruption

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Time alone will not solve the global Great Supply Chain Disruption, as The New York Times reported. “It’s unlikely to happen in 2022,” said Phil Levy, chief economist at Flexport, a freight forwarding company in San Francisco. “My crystal ball gets murky further out.”

 

  • What is required are investments, technology and a refashioning of the incentives at play across global business. It will take more ships, additional warehouses and an influx of truck drivers, none of which can be conjured quickly or cheaply.
  • Mayhem at factories, ports and shipping yards, combined with the market dominance of major companies, is a key driver for rising prices.
  • Cheap and reliable shipping may no longer be taken as a given, forcing manufacturers to move production closer to customers. The crunch has companies across various industries warning of delays or effects to profits.
  • For the global supply chain, the very concept of a return to normalcy has given way to a begrudging acceptance that a new normal may be unfolding.

Situation in the US

It was therefore about time that the US Congress passed the Infrastructure Investment and Jobs Act (IIJA) back in November 2021, as reported in ISGAM’s last Manager’s Report. Plans include significant funding for ground transportation, that would help improve economic productivity, as well as modernizing the power grid and making it more resilient and sustainable, including clean energy sources. The bi-partisan USD 1.2 trillion plan splits USD 650 bn in re-authorized spending and USD 550 bn in new expenditures.

Meanwhile it is looks increasingly unlikely that President Biden’s broader economic agenda will garner enough votes to pass before the midterm elections.  So further fiscal stimulus is unlikely to be forthcoming in the US.  Having said that, consumers and businesses remain in decent shape, with a strong jobs market, high cash balances and low debt compared to before the pandemic, so we expect the US economy to retain positive momentum once the Omicron wave of infections passes.

To read the complete Manager’s Report, please visit our client login area or contact us.

Date: 3 February 2022

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Manager’s Report published on 31 December 2021

The New York Times article published 1 February 2022 by Peter S. Goodman

Contact: enquiry@isgam.ch

This document is prepared for educational and informational purposes ONLY, by ISGAM AG. Please click here for the important information. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. The information provided is not to be treated as advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. Past performance is not a reliable indicator of future performance.

 

 

 

Inflation Outlook for 2022

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We have previously highlighted the different inflationary pressures building in the global economy, especially in the US and to some extent in the UK (where the Bank of England delivered a surprise rate hike in December, lifting the base rate to 0.25% from 0.1%)

 

Part of these pressures are due to the rapid restarting of activity after COVID lock downs and resulting imbalances in supply and demand, and thus transitory in nature.  But there has been increasing evidence of more durable inflation emerging in the US economy, led by wage pressures and cost of shelter.

Before the new, virulent “Omicron” variant of the COVID virus spread, some of the worst supply/demand imbalances in the global economy had started to ease and growth momentum was again picking up; current estimates for real GDP growth in 2021 are 7% for the UK, 5.5% for the US, 5% for the Eurozone.  But high infection rates are once again starting to wreak havoc with labour supply, even though the US and UK are unlikely to resort to the tough containment measures many European countries are adopting.  Until the Omicron wave crests it will have the effect of temporarily dampening growth and further increasing inflation.

Chart 1) Estimates of the Path of Headline CPI Inflation, by Capital Economics

Sources: Capital Economics, Refinitiv

It is notable that inflation in the eurozone is expected to fall back below the ECB’s 2% target level by the end of this year, while inflation in the US is expected to settle at 3%: not too high for comfort but above the Fed’s recent 2% target, and above the recent (post Great Financial Crisis) levels.

What is also notable is that, despite its newly found hawkish tone, the Federal Reserve’s own “dot plot” indicates they see the longer-term peak in the Federal Funds rate at 2.5%; considerably below previous peaks and below current estimates of where CPI inflation will settle.  Meaning that “real” (after inflation) interest rates, though increasing, are expected to remain negative.  As stock market valuations are influenced by the level of real interest rates, this bodes well for the continued attractiveness of stocks as an asset class.  Though the trajectory of the market is likely to become more volatile in a rising rate environment, the positive risk premium offered by stocks remains well supported.

Chart 2) FOMC “Dot Plot” 15 December, compared to market estimates

 

Source: Bloomberg Finance LLP

Market estimates of the Fed’s coming rate hike path (as expressed by the Overnight Indexed Swap (OIS) rate and Fed Funds Futures), have adjusted to the Fed’s median estimates up until the end of 2022, but remain below the projected trajectory for 2023 and 2024, perhaps fearing that renewed waves of COVID will depress economic activity and cause the Fed to backtrack on its path to normalization.

Chart 3) Level of Real US Interest Rates – using 5 year and 10-year inflation estimates

Source: Bloomberg Finance LLP

The chart above shows the nominal 10-year US Treasury yield (orange line) compared to the market-derived real (after inflation) yields on the 5-year (blue line) and 10-year (black line) Treasury bonds – these remain deeply negative, hence our negative view of Developed Market government bonds as an asset class.

Meanwhile, corporate earnings estimates have increased in line with stock prices.  Also, despite paying higher wages and input cost inflation, most companies have been able to pass increased costs on to their clients and profit margins remain at an all-time high.  When it comes to stock selection though, identifying companies with pricing power is imperative.

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Manager’s Report published on 31 December 2021

Featured Image Source: Bloomberg Finance LLP, Capital Economics, Refinitiv

Contact: enquiry@isgam.ch

This document is prepared for educational and informational purposes ONLY, by ISGAM AG. Please click here for the important information. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. The information provided is not to be treated as advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. Past performance is not a reliable indicator of future performance.

 

 

In The News: European Natural Gas Supply and Russia

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European gas surged on signs Russia won’t deliver the boost in supplies President Vladimir Putin promised.

Russia, a key supplier of European gas, has been sending the bare minimum of natural gas to Europe to what is contracted. This is possibly to put some pressure on the politically controversial approval of its new Nord Stream 2 pipeline, a recently completed project that will let Russia transport gas directly to Germany without needing to pay distribution costs to the Ukraine or Poland for transporting it through their pipelines, as is the current situation.

Keep reading to find out more about the current natural gas supply situation, from an excerpt of our Manager’s Report by ISGAM’s Portfolio Management team:

A supply crunch in natural gas has sent prices soaring with Europe already in the throes of an energy crisis.

Gas prices are notoriously volatile and gas contracts are traded regionally.  The US, Canada, and Mexico trade among each other and are also exporters.  Other top exporters are Qatar, Australia, and Russia.  Asia and Europe are importers and in competition with each other for liquefied natural gas (LNG) imports.  The main culprit for this year’s surge in demand, as well as lack of supply of gas is probably the weather.  Unusual weather patterns have meant elevated demand for both heating and cooling when it is usually not needed.  Extreme weather events including Hurricane Ida also effected supply at times.  There have been disruptions to oil and gas supply in the US and Australia.  Droughts in countries including Brazil caused a lack of hydro power.  Unusually low wind output and nuclear power plant outages have exacerbated the power shortage.  Meanwhile China’s strong economic recovery earlier this year meant a big increase in energy demand; high prices offered by Asia to secure LNG imports resulted in less offer to Europe.  At the same time Russia, a key supplier of European gas, has been sending the bare minimum of natural gas to Europe to what is contracted. This is possibly to put some pressure on the politically controversial approval of its new Nord Stream 2 pipeline, a recently completed project that will let Russia transport gas directly to Germany without needing to pay distribution costs to the Ukraine or Poland for transporting it through their pipelines, as is the current situation.

The result has been a surge in Dutch TTF front-month gas prices (a European benchmark) to as high as euro 160 per megawatt hour on 5 October – up from just euro 19.80/MWh at the start of the year.  Meanwhile, European gas storage for the winter months is only 71% of capacity, compared to the usual seasonal norm of 92%.

Russia does need to balance its desire for approval of Nord Stream 2 with being regarded as a dependable supplier by Europe; at the time of writing Dutch TTF gas has eased back to 108 euros/MWh after an assertion from Vladimir Putin, on urging of the IEA (International Energy Agency), that his country is ready to help stabilize global energy markets. However, as we can see in the news as of beginning of November, Russia won’t be delivering the boost in supplies after all.

As gas and coal are often interchangeable in power generation, coal prices have also been driven up.  Oil prices too have been trending higher, for a different reason: OPEC has not raised output as much as it had promised. Under more normal supply/demand conditions, the medium term sustainable natural gas price is seen to be around 20 to 30 Euro/MWh, but prices are likely to remain volatile and elevated until after the Northern Hemisphere winter, i.e., Q2 2022.  How elevated will depend, again, for a large part on the weather – whether this winter will be mild or cold.

Renewable energy sources will, in the long run, be far cheaper and less volatile than coal and gas, but we still lack the technology for sufficient storage capacity for wind and solar energy which is why they are used alternately with gas and coal, depending on how much is generated – this transition phase will last a while yet. The question is, if eventually, these will enable Europe to remain independent in its energy supply in the future.

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Manager’s Report published on 30 September 2021

Featured Image Source: Bloomberg

Contact: enquiry@isgam.ch

This document is prepared for educational and informational purposes ONLY, by ISGAM AG. Please click here for the important information. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. The information provided is not to be treated as advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. Past performance is not a reliable indicator of future performance.

Summary of Manager’s Report for the 3rd Quarter 2021

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After a relatively quiet summer, the third quarter ended in a decidedly “risk off” mood as several global topics are dominating news headlines and coming to the fore of people’s worry list, detracting from the ongoing re-opening of public life, and accompanying economic revival.

Here is a short overview of the current issues (in no specific order):

  • The recent surge in energy prices, particularly the price of natural gas, especially in Europe
  • How these add to already elevated headline inflation numbers
  • Whether this will throw the nascent economic recovery off course
  • Ongoing supply shortages and distribution bottlenecks as demand surges while economies reopen; in the UK these are aggravated by the effects of Brexit
  • The partisan standoff around the imminent debt ceiling in the US (at the time of writing this appears to have been temporarily resolved until later this year)
  • A potential default by a highly indebted large property developer in China, and its consequences for the global financial system
  • The recent regulatory crackdown by Chinese authorities on certain private companies in the technology, healthcare, and educational sectors
  • The effect that “tapering” of monthly bond purchases by the US Federal Reserve, expected to begin towards the end of this year, will have on bond yields and financial markets

How they relate to our investment strategy, you will find at the bottom of this summary.

The unusual nature of the current economic recovery after a deep, intentionally induced economic slump caused by COVID lockdowns, makes the interpretation of economic data very complicated, almost like in the aftermath of a war. 

Unlike during a war, the production capacity of the economy has not been destroyed, consumers have been supported by governments via furlough schemes (in Europe) or direct cash transfers (in the US), so most economists do not expect “lasting damage” to the global economy.  It is however clear that, in moving from an almost complete standstill of much activity to a resumption of “normal” consumption patterns, there are many (temporary) mismatches in supply and demand, bottlenecks, and supply constraints, besides the ones in the energy market described above.  In the UK, the combination of the reopening of services combined with the fact that Brexit caused an exodus of non-British workers means acute shortages of skilled labour in transportation, the meat industry, healthcare, and other sectors.  In the US, the labour force remains some 3 million people short of pre-pandemic levels; partly because some older workers chose to retire, perhaps partly because not all feel safe yet to return to work given the Delta variant, or due to a lack of childcare facilities; in any case a shortage of skilled labour is quoted as a main concern by many companies.

This is putting upward pressure on wages.  Walmart, a huge employer in the US (accounting for 1.6 million jobs), recently announced it would increase its minimum wage to $ 12 an hour, and its minimum wage at its Sam’s Club division to $ 15 an hour, amid a tight labour market.  Meanwhile Amazon, another large US employer (1 million US jobs), is increasing its average starting wage to $ 18 an hour, and recently instated a minimum wage of $ 15 an hour.  This is good news for many US families and for the US economy as it will support US consumer spending.  It will also make inflation perhaps less transient than the US Federal Reserve is expecting.  In the EU, workers have remained more “attached” to their jobs via the furlough schemes, and wage inflation due to a mismatch in supply and demand is less prevalent.

How much inflation is too much?

The past two decades have been characterized by unusually low inflation; policy makers have been battling the risk of “deflation”, especially since the 2008 financial crisis.  The graph below shows US consumer price inflation, for all items (blue line) as well as “core” inflation excluding food and energy costs (black line) for the post World War 2 period.

US inflation – Core CPI vs headline CPI, post WW2

 

Source: Bloomberg Finance L.P.

The recent jump in inflation is partly due to “base effects”, as figures are quoted as year-on-year change and include the lockdown period of 2020 when energy prices plummeted and demand for certain services completely dried up.  In European statistics, prices for such services (like airline tickets) were imputed for purposes of index calculation, whereas in US statistics these prices simply fell out of the index so the jump in US inflation looks stronger than in Europe partly because of this difference in calculation methods.  Economists estimate that, for G4 economies, 60% of the current inflation increase is due to energy prices, 20% is due to shortages, and 10% is due to “reopening” inflation; together accounting for 90%.  Energy inflation is likely to fall next year as the base level changes; it is still an open question how sticky shortages and demand/supply mismatches in goods and labour will turn out to be.  In some areas with supply shortages, like shipping, it takes time to build new vessels and increase supply.  Also, the demand for semiconductors still outstrips available production.  Labour shortages and resulting wage inflation are likely to remain stronger in the US and UK than in the Eurozone, for reasons explained above.

All in all, we think headline inflation will fall back next year, due to energy prices and base effects, while core inflation will fall more in the Eurozone and Japan than in the US and UK.

In Developing Economies food prices are a larger share of the consumer basket; extreme weather conditions including droughts have pushed up the price of many foods.  Despite this, inflation in Developing Economies is on average just over 4% currently, which is not that high by historic standards.

Are we headed for a period of persistently higher inflation?  And if yes, how will central banks deal with this? 

This has been a topic of some debate and investor angst.  Analysing history makes clear that economies and financial assets perform well during periods of relatively stable, positive inflation, up to around 4%.  Periods of negative inflation (deflation) or high inflation (5% or higher) are more problematic.  The past two decades have been characterized by unusually low inflation, hardly ever exceeding 2% in developed economies.

What does all of this mean for our investment strategy, and portfolio positioning?

  • Global equities remain the most attractive asset class. Though 10-year bond yields may rise a bit, especially in the US, they will be capped by Central Bank purchases for some time to come.  Equity valuations are more reasonable after the recent correction and are justified by low interest rates and continued earnings growth expectations.  We suspect that inflationary trends evident in the US today are a bit less “transient” than the Fed seems to believe.  There is evidence of wage pressures which could lead to medium to longer term inflation in the US and possibly the UK being a bit higher than the 2% to which we have become accustomed.  Historically, in periods of moderate inflation (up to around 4%) equities are the best asset class to preserve investment capital.
  • We are mindful to include some “value” stocks in portfolios but are careful to avoid value traps and maintain a focus on companies and sectors that enjoy secular growth momentum, many of which can be found in the technology, healthcare, communication, and industrial sectors. Companies that will profit from the coming boom in infrastructure investment, and the transition to clean energy, are also firmly on our radar.  We maintain a slight overweight to funds in smaller companies in global equity portfolios, as real (after inflation) interest rates remain deeply negative; usually an environment in which small caps can outperform.
  • We used the positive market sentiment earlier in September to take some profits in equities for clients whose equity allocation had grown to be more than 5% overweight their chosen “neutral” allocation. The resulting cash will be invested in the Alternatives section of the portfolio.
  • Alternative asset classes (private Equity, long/short equity strategies, event driven strategies, global real estate) offer appreciation potential and diversification/hedging benefits.
  • In bond portfolios we retain an overweight to High Yield and Emerging market bonds, and underweight duration.

As always, please do not hesitate to contact us if you have any questions or comments, about the contents of this report or your portfolio in general.  We hope you are safe, and well, and keeping in good spirits in these unusual times.

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Publishing Date: 30 September 2021

Contact: enquiry@isgam.ch

This document is prepared for educational and informational purposes ONLY, by ISGAM AG. Please click here for the important information. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. The information provided is not to be treated as advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. Past performance is not a reliable indicator of future performance.

Ten Key Guidelines For Success In Investing

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Investors and their Decisions 7 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 7th and last one, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process and if so, what the practical consequences and applications are. This is the third article addressing managing these other factors (biases). This is the last article the author writes for OB Golf & Leisure Magazine. He thanks the editors for enabling him to share perspectives and ideas about personal finance with their readership and wishes the readers success on their paths of investing.

Ten Key Guidelines For Success In Investing

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DATA INVESTORS NEED TO PUT IN THEIR “COMPUTER”

In my previous 6 articles, I have tried to give answers to the startling fact that investors underperform the markets with several percentage points p.a. Aiming to explain this worrying fact, I introduced readers to the perspectives of Behavioural Finance, which suggests that people (investors) are prone to biases in their decision making progress- both cognitive and emotional biases.

For perspectives about possible remedies, I introduced readers to the workings of our brains, as put forward by Daniel Kahneman (1). I applied Kahneman’s concept of the fast and slow part of our brains to the investor making process and suggested investors use the slow part of their brain as a remedy against bias-prone investment decision making. I then discussed how a theory, successfully used in elite sport, also can be applied to investors in their decision making process: the theory of Dr Steve Peters (2).

I specifically addressed how investors can manage their “Inner Chimp”. In this concluding article to the series, I will discuss one more action investors could take to promote the making of sound investment decisions. This argument still follows the ideas of Dr. Steve Peters: to put “sound data” in the Computer part of our brain.

Summarizing Dr. Peter’s perspective about the functioning of our brain, simply put (3), there are three mechanisms with different characteristics working in our brain:

  • The Chimp which is emotive and irrational;
  • The Human which has self-control;
  • The Computer which thinks and acts automatically, using programmed thoughts.

Key is the interphase between these 3 parts. Particularly challenging is that these three parts react to what comes to us with different speeds. As I mentioned, in a previous article (again, according to Dr.Peters’ theory), the Chimp in our brain reacts 5 times faster than the Human (4).

According to Dr. Peters’ theory, the Computer has, in fact, the fastest speed of all three: 20 times faster than the Human and 4 times faster than the Chimp. So, it is essential that this Computer contains “sound data”. Naturally, this raises the question- what qualifies as “sound data”?

Readers when googling “investment wisdoms” will find several interesting notions about investing. These are often contradictory and more worryingly, either directly or indirectly promote the idea that amateur investors can outperform the market. So, they do not qualify for the “sound data” I am recommending. This author’s 10 suggestions about “sound data” takes to some extent a leaf of John Bogle’s 10 lessons (5), but takes a very different perspective on the role of advisers. Note: John Bogle is the founder of the Vanguard Group.

The critical 10 Key Data investors need to store in their Computer are:

1. INVESTING AND SPECULATING ARE DIFFERENT ACTIVITIES
When investing you aim for returns over the long term (minimal 5 yrs plus), by participating in the long term returns capital markets offer. When speculating you aim for returns in a day, week or month, aiming to profit from specific opportunities. These are both legitimate activities, but different, and need to be distinguished from each other.

2. MARKETS ARE THERE TO PARTICIPATE IN, NOT TO BEAT THEIR RETURNS
Trying to beat the market, or trying to find managers who do, is not the purpose of investing. This is a “losing game” anyway (6). Investors invest to meet personal goals and when materializing returns (net of costs) close to market returns they do great.

3. ASSET ALLOCATION IS THE KEY DRIVER
Asset allocation (between asset classes such as stocks, bonds and alternative investments) is key and the driver of performance. Decide on major adjustments, not because of market conditions, but because of changes in your investment goals.

4. RETURN AND RISK GO HAND IN HAND
This is stating the obvious…or is it? Are you familiar with: “getting maximum returns with minimal risk”? This is a mythical notion that does not equate to “sound data”. There is no escaping this fact: risk and return go hand-in-hand.

5. TRENDS COME AND GO. WHEN DIVERSIFIED, AT TIMES, TRENDS WILL GO YOUR WAY, AT TIMES THEY WILL NOT
In a diversified portfolio, it is inevitable that some parts will do well and others not. Anticipating trends consistently is impossible. Following trends incurs costs and most times you will be too late.

6. BE AWARE OF REVERSION TO THE MEAN
What’s hot today isn’t likely to be hot tomorrow. Investments invariably tend to reverse to the mean (7).

7. TIME IS ON YOUR SIDE
Take advantage of compound interest (8). Take both the large upswings as well as downswings with a healthy measure of salt.

8. HAVE REALISTIC EXPECTATIONS
The goal of investing is not to get rich quickly. For USD investors, numbers mentioned by John Bogle, can be a guideline: 7.5 per cent annual return for stocks and a 3.5 per cent annual return for bonds (9). Remember: it is only a guideline.

9. PAY ATTENTION TO COSTS BUT ACCEPT GRACEFULLY THAT ADVICE COMES WITH A PRICE
Costs matter. However, good advice or investment management will help you get the satisfactory returns you are looking for and is worth the price. Our bias prone decision making process is as much an enemy as costs are.

10. STAY THE COURSE
The secret to investing is there is no secret (10). This is the “Zen” of investing. When you own a well diversified portfolio, investing in the various asset classes, well selected with an eye on costs, you have the optimal investment strategy. Discipline is best summed up by staying the course (11).

Putting “sound data” in the Computer part of our brains, is not a one time action for investors but a continuous process. Keep reverting to the 10 listed in this article; it may help keep the Chimp at bay, with that the biases and so enable investors to get the performance of their investments they are looking for.

Written by Frank R. van Lerven.
CFP® Professional

 

Sources:

(1) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012
(2), (3), and (4) “The Chimp Paradox, The Mind Management Programme for Confidence, Success and Happiness” by Dr. Steve Peters, Vermillion, an imprint of Ebury Publishing, a Random House Group company, 2011
(5) Allen Roth, discussing “The Clash of the Cultures: Investment vs. Speculation” by John Bogle and quoting Bogle’s 10 rules for Investing, in Money Watch 22 August 22
(6) From: “Winning The Loser’s Game” by Charles Ellis, The McGrawhill Companies, 5th edition 2010
(7), (8),(9),(10,(11) All part of John Bogle’s 10 lessons, as discussed by Allen Roth, see (5)

Investors And Managing The Chimp Within Us

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Investors and their Decisions 6 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 6th, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process and if so, what the practical consequences and applications are for investors. This is the second article addresses managing these other factors (biases).

Investors And Managing The Chimp Within Us

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MANAGING YOUR MIND—THE CHIMP WITHIN US

In my last article, Investors and Their Decisions – 5, I suggested a practical remedy for investors to protect themselves from allowing biases to hinder investment results: work with a portfolio manager and/or a well-formulated investment policy. In this article I want to delve a bit deeper into ‘the workings of our mind’ and introduce readers to a theory that is currently being successfully used in top sports but lends itself well to fruitful investing too.

It is a theory, credited by – amongst others – Sir Chris Hoy, Bradley Wiggins and Victoria Pendleton (all Olympic gold medal winners in cycling) to have contributed to their successes (1). This theory was developed by Dr Steve Peters and published in his highly readable book “The Chimp Paradox “ (2). Let’s see if investors can benefit from the application of this theory!

Note: I do not claim in any way to represent Dr Steve Peter’s views, nor to have his consent to my interpretations. For a full understanding, readers need to read “The Chimp Paradox” themselves.

In my previous articles addressing biases and the notion that investors often make decisions that were not necessarily based on rational considerations, I often refer to ‘behavioural finance’. Dr Steve Peters is a psychiatrist and certainly not known for contributions to the realm of behavioural finance. However, Dr Peters begins with an explanation of how our brains work, and offers a working model that is not only easy to understand (3) but that can also be considered in the context of behavioural finance- particularly the area of behavioural finance my articles have focussed on.

Peters introduces us to the part of the brain he terms the “Chimp”. The “Chimp” refers to one part of our brain (the limbic brain) that works like an “emotional machine” (4). More interestingly, this emotional part of our brain, once activated and in motion, is ever so strong and works 5 times faster than the more ‘human’ parts of our brain (5). The “Chimp” is so called because its workings show many similarities to the behaviours of chimpanzees.

The basis for the “ Chimp’s” thinking are impressions and feelings. Here are some elements that make up the “ Chimp” “identity” (6):

  • Jumps to an opinion
  • Thinks in black and white
  • Prone to paranoia
  • Prone to catastrophic thinking
  • Irrational
  • Emotive judgement
  • Responds to danger by attacking or fleeing (7).

The good news is (still staying with Peters’ theory) that there are two further brain parts relevant to decision making processes: the “human” part and the “computer” part (8):

  1. The human part represents self-control, honesty, compassion, conscience, law-abiding, sense of purpose and achievement & satisfaction.
  2. The computer part thinks and acts automatically, using programmed thoughts and behaviours. It is a reference source for information, beliefs and values.

It is the interplay between “the chimp”, “the human” and “the computer” which is responsible for the decisions we make. Essential for a “high quality interplay” is to familiarize ourselves with the “chimp” within us. Once familiar, we stand a chance to manage the “Chimp”.

In the words of Dr. Steve Peters: “the chimp is an emotional machine that thinks independently from us. It is not good or bad, it is just a Chimp” (9).

There are many characteristics to the “Chimp” within us; as I mentioned, Peters’ book makes for a very fine read. One of them is that the “Chimp” has a strong need to be part of a “troop” (11). Herd instinct, following the crowd etc…sound familiar? Investors often making investment choices (buying, selling or holding) because friends/colleagues do…

So, what are some practical suggestions to help Investors keep their “Chimp” in check?

INVESTORS MANAGING THEIR “CHIMP”

Dr. Peters identifies three ways to manage our chimp: exercising it, boxing it and feeding it (12). For investors this can mean the following:

FEEDING THE CHIMP :
With small amounts, from time-to-time make a clearly speculative investment. For the “ Chimp” it will function like a “banana” (13). And/or, again with a small amount, follow a friend, colleague in a ‘hot tip’ investment.

BOXING THE CHIMP :
Recognize the “Chimp’s” existence. Do not fight the biases, the irrational responses when they come up. Instead, recognize them. This will “re-assure” the “Chimp” of its existence, that it has a place (remember, chimpanzees are territorial). The Chimp can then be “boxed” (14), or set aside to allow investors to make considered decisions, which in many cases requires time.

EXERCISE THE CHIMP :
Have a gambling account or a frequent trading account, with a small part of your investable assets. An account where you allow yourself to act impulsively and quickly, following emotions and snap judgements. This kind of account will satisfy the “Chimp’s” need to be active.

There is an important role for the computer part of our brain. I will tackle this in my next article.

Written by Frank R. van Lerven.
CFP® Professional

 

1) till 14) “The Chimp Paradox, The Mind Management Programme for Confidence, Success and Happiness” by Dr Steve Peters,
published 2011 by Vermillion, an imprint of Ebury Publishing, a Random House Group company

How Investors Can Manage Biases

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Investors and their Decisions 5 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 5th, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. This article addresses Managing these other factors (biases).

How Investors Can Manage Biases

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MANAGING BIASES

In previous articles, I have aimed to familiarize the reader with a range of biases, cognitive as well as emotional ones, which can stand in the way of making sound investment decisions. The concept of ‘biases’ and their potentially damaging effect on decisions made by investors, belongs to the realm of Behavioural Finance, a theory developed by, among others, Daniel Kahneman.

In his bestseller “Thinking Fast and Slow”, Kahneman covers 40 decades of research on matters to do with the human mind and how it works. His book is not an easy read and is impossible to summarize. Simply said though, Kahneman attributes the influence of biases in our decision making process to the fact that we are prone to use the Fast Part of our brain (“System 1”) rather than the Slow Part of our brain (“System 2”) (2).

The list of biases is long, ranging from “over confidence” to “risk aversion”, all discussed in my previous articles. Is there anything investors can do to avoid these biases, stay clear of them or at least manage them? Is there anything investors can do to tap into the Slow Part of their brain rather than the Fast Part? Daniel Kahnman’s view is quite clear: “little can be achieved without a considerable investment of effort”.

Knowing about these biases by itself is certainly no guarantee at all that one is less prone to be subject to them. Kahneman says: “except for some effects that I attribute mostly to my age, my thinking is just as prone to overconfidence, extreme predictions, planning fallacy as it was  before I made these studies.” (3). There is hope though; for while in Kahneman’s words, “our thinking is prone to biases”, whether we act on bias-prone thinking is quite a different matter.

Biases play a role in every aspect of life and the journey to discovering our biases and then managing them can be viewed as part of a process of self-awareness. In the following articles, I will cover one or two perspectives which may be applicable to investors and their decision making. For now, though, there are for investors two practical ways to manage biases when it comes to investment decisions:

  1. Working with an investment adviser/manager;
  2. Working with an investment strategy & risk policy.

WORKING WITH AN ADVISER/PORTFOLIO MANAGER

Most investors will not be prepared to put in the “considerable effort” Kahneman is speaking about (4). I advise them to work with an investment adviser/manager who has made it his/her business to do so. The best guarantee to find this kind of quality adviser/ manager is to look for someone with a CFA designation.

Note 1: As I myself am part of a portfolio management firm with a manager at the helm who does have a CFA, I must immediately acknowledge my own bias on the matter;
Note 2: Sourcing Kahneman’s ideas, does not mean that I fully subscribe to his theory or that Kahneman support’s my advice.

My view is that there is a significant benefit in working with a portfolio manager who has discretionary authority, for many reasons. One is that it puts distance between the investor and his investments. So, while the biases may come up in the investor’s mind, they are not actionable. If Kahneman is right, it is the impulsive actions in response to bias which does the damage. Working with an adviser can eliminate such impulsive actions, and thus their potentially damaging impact.

The CFA designation (granted by the CFA Institute) earns its reputation mainly due to the gruelling process candidates must endure to earn the CFA charter. While the exam is very democratic and open to anyone with a bachelor’s degree, the only people with a realistic chance of passing are those who are serious about the field. The three general requirements to earn a CFA charter are to pass three exams, have an undergraduate degree (in any subject) and have three years related work experience in the financial area. (5)

Note: Investors who are not prepared or able to work with an adviser in a cooperative model or one where authority is delegated, are well advised to:

  • Put the same effort & work in that those do who complete their CFA accreditation;
  • Guard themselves against any notion that it takes little time to get educated.

INVESTMENT STRATEGY AND RISK POLICY

Central in all efforts, whether working with a portfolio manager, an adviser or making all investment decisions oneself, needs to be a well formulated investment strategy & risk policy. While this kind of policy may not be able to have answers for some of the curveballs financial markets throw from time to time, it will definitely guide investors (and their advisers) with their decisions through most market conditions. And again, perhaps most importantly, such a policy will stimulate the Slow Thinking of our minds, rather than the Fast (impulsive and often bias prone) part of our minds.

Written by Frank R. van Lerven.
CFP
® Professional

 

1) “Managing your Mind, the key to everything else” by Jack Speer, 13 Oct 2013, www.delta-associates.com
2), 3) and 4) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012
5) www.Investopedia.com

Investors And Emotional Biases

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Investors and their Decisions 4 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 4th, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. This article addresses Emotional Biases. An emotional bias is a distortion in cognition and decision making due to emotional factors (1).

Investors And Emotional Biases

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EMOTIONAL BIAS: BEWARE OF AVERSION OF LOSS!!

Consider these two problems (3); Which do you choose?

Problem 1: Get $900 for sure OR 90% chance to get $1000

Problem 2: Lose $900 for sure OR 90% chance to lose $1000

Most likely, if you are like the thousands of respondents before you, you will have selected the “$900” risk-averse option in problem 1. Most likely though as well, you will have selected the “90% chance to lose $1000” gamble option in problem 2. How come?

This is the explanation of Nobel prize winner Daniel Kahneman, in his widely acclaimed book “Thinking Fast and Slow” (4). It is the central theme in what is known as “prospect theory” and it has considerable implications for investors. In Kahneman’s words:

“The explanation for the risk seeking choice in Problem 2 is the mirror image of the explanation of risk aversion in Problem 1: the (negative) value of losing $900 is much more than 90% of the (negative) value of losing $1000. The sure loss is very aversive, and this drives you to take the risk.”

Hundreds of experiments have been done, on these lines, all leading to similar conclusions. This has led Kahneman to say that “Losses are weighed about twice as much as gains in several contexts”. That we humans are highly motivated to avoid loss (read: pain) is not new.

Skinner’s traditional psychology (behaviourism) also noted that humans (like animals) will move away from any stimulus causing pain and will move toward any stimulus offering rewards. Where behavioural finance brings in a new element is that avoiding losses outweighs seeking gains significantly.

LOSS AVERSION AND THE NEGATIVE IMPACT ON INVESTORS

Here are some examples of how the bias of loss aversion can have a negative impact on investors and their decisions:

  • Hanging on to losing investments, when better, alternative options are available; Taking profit on profit making investments rather than realizing losses on loss making investments, even when the profit making investments have better prospects than the loss making investments (disposition effect);
  • Investing additional resources in a losing account when better investments are available (sunk-cost fallacy);
  • Selecting funds which have not shown any downside (only to experience the downside once participating).

THE LETHAL COMBINATION OF LOSS AVERSION AND NARROW FRAMING:

FOLLOWING INVESTMENTS DAILY AND EXPOSING YOURSELF (UNNECESSARILY AND WITH NO USE) TO LOSS AVERSION

It is a fact of life that financial investments go up and down (stocks more than bonds, individual securities more than indices and so forth). Investments fluctuate. The level of fluctuation is often taken as the measure of risk. So, investors who follow their investments daily are going to experience both gains and losses on an almost daily basis.

If they take a broad “frame”, like the professional trader, there is no problem. The professional trader expects (or so he should) the daily ups and downs and is not emotionally affected. However, the amateur, the private retail investor, may use a “narrow” frame, focussing on the now. In that case (according to prospect theory) he will be far more affected by the daily losses than the daily gains and will be prone to taking counter productive actions such as churning one’s portfolio.

This is what Kahneman says on the matter (5):

Closely following daily fluctuations is a losing proposition because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and maybe more than enough for individual investors”.

In short, this is the message of behavioural finance: loss aversion is not helpful to participate in the superiors gains financial markets over time offer to private investors. For this reason: investors beware of inversion to loss!

RISK AVERSION IMPACTS GOLFERS AS WELL!

Prospect theory predicts that our stronger motivation to avoid losses than to achieve gains would show up in golf as well (6). Golfers near the hole are confronted with a choice: to putt to avoid a bogey (loss) or to putt to achieve a birdie (gain). This was tested by two economists (Pope and Schweitzer) (7). More than 2.5 million putts were tested (including those of Tiger Woods). The result: whether the putt was easy or hard and at various distances from the hole, players were more successful when putting for par than for birdie. The conclusion (8) being that sub-consciously golfers  put in just that bit more extra-concentration to avert loss (bogey)

Written by Frank R. van Lerven.
CFP® Professional

 

Sources:
(1) Wikipedia
(2) “When averting loss can lead to averting gains”, 11 October 2012, Beyond Bulls&Bears, Franklin Templeton
Investments
(3), (4), (5), (6), (7), (8) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012

Investors And Cognitive Biases (Continued)

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Investors and their Decisions 3 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 3rd, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. The previous article and this one address “Cognitive biases” which may affect investors to make decisions on a non-rational basis.

Investors And Cognitive Biases (cont.)

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OVER CONFIDENCE!

In my first article in the series (“Homo Economicus?”), I signalled that the concept of people (read: investors) making decisions rationally has become under fire by a relatively new approach to economic theory: behavioural finance, also referred to as behavioural economics. Behavioural finance identifies many biases. Two types can be recognized: cognitive and emotional biases. This article and the previous one discuss cognitive biases. Cognitive biases affect the way we think and can cloud our judgments.

The three cognitive biases discussed in the last article were:

  • Anchoring (fixing your mind on a specific number)
  • Bandwagon (joining the crowd)
  • Gamblers Fallacy (setting expectations to what is random).

I will now discuss three more:

  • Over-confidence (excessive confidence in ones own abilities)
  • Representativeness (making decisions based on stereotypes)
  • Myopia (short term-ism)

OVER-CONFIDENCE: EXCESSIVE CONFIDENCE IN ONES OWN ABILITIES

Refers to our boundless ability as human beings to think that we are smarter or more capable than we really are (1) We have too much faith in the precision of our estimates(2).

CLASSICAL EXAMPLE: 82% of people asked (in an experiment) say they are in the top 30% of safe drivers. When people say (again in an experiment) that they are 90% sure they are right about something, they are actually right 70% of the time. (3)

INVESTOR EXAMPLE I: “I can read markets, trends.., figure out when markets will crash and when they will take off.”
INVESTOR EXAMPLE II: “My skills as an investor are better than others”. (4)
INVESTOR EXAMPLE III: Tendency to attribute good investment results to one’s ability to make the right decisions, and bad results to “the markets”. (5)

REPRESENTATIVENESS

When we make decisions based on stereotypes, characterizations that are treated as “representative” of all members of a group. Recognizing an event that is similar to something we have seen elsewhere, and often incorrectly conclude that this event will be the same (6).

CLASSICAL EXAMPLE: When we see a man running out of a bank wearing a ski mask, assuming that he is a bank robber. (7) Note: what we are doing is using the ski mask and the running to represent the activity of robbing.
INVESTOR EXAMPLE I: Treating past performance of e.g. an investment fund as indicative of future results (without looking at any other data).
INVESTOR EXAMPLE II: Identifying a significant even such as stock market crash (e.g. Oct 1987, Autumn 2008) as a similar event as the 1929 depression. (8)

MYOPIA (SHORT SIGHTEDNESS)

A tendency in decision makers to focus on information immediately related to their judgment and to ignore other (less prominent) pieces of information (9). The tendency to being overly pre occupied by short term events.

CLASSICAL EXAMPLE: “Tip of the iceberg”: when we focus on only the part of something that can be easily observed, but not the rest of it, which is hidden. (10) (Referring to the fact that the majority of an iceberg is below the surface of the water.) Note: often (mis)used in an alarmist way to strengthen an argument.
INVESTOR EXAMPLE I: Short-termism: buying or selling based on an immediate (economic, political) event.
INVESTOR EXAMPLE 2: “Buying what is hot”. Making an investment decision based on the recent (strong performance). Today it would be US Large Cap, a few years ago it was Emerging Markets.

Benjamin Graham, the original value investor, warned against myopia when he famously remarked: “In the short run the market is a voting machine but in the long run it is a weighing machine !” (11)

Our inclination to cognitive biases is also used in marketing, advertising and promotional material to entice us to buy and by the media and news channels to get our attention. So private investors need to be aware of what is coming at them!! This is also where educated financial planners can play a crucial role.

Written by Frank R. van Lerven.
CFP
® Professional

 

Sources:

(1), (3) and (4) “Psychology and Investing”, 25 February 2013, www.morningstar.co.uk
(2) and (5) Investor Behaviour 13.1 www.web-books.com/eLibrary/NC/B0/B65/61MB65.html‎
(6) and (7) “Rational Investment” www.rtnlblog.net
(8) “Heuristics in Investor Decision making”, The Journal of Behavioral Finance
(9) and (10) “Psychological myopia: a tendency to think shortsightedly”
www.understandinghuman.com
(11) “A long history of myopoc investing” by John Plender, www.FT.com 15 May 2011