Rely on logic, not emotion in investing
IF a healthy relationship breaks up over a moment of emotional irrationality, the loss of decades of foregone happy cohabitation is an unnecessary travesty.
Just as a great relationship can be brought to an end impulsively in a moment of trial, even the best unit trusts can generate poor returns for those clients who exit the fund at the wrong time.
Such a tragic break-up is to the detriment of both the client and the asset manager.
Often long-term relationships stand us in good stead, and it is common knowledge that investing in a unit trust should be a long-term endeavour.
In fact, very few unit trust investors would claim to follow a short-term approach.
Why then, do so many investors panic, and sell at or near the bottom of a fund’s performance?
Simply, because it is not easy making long-term investment decisions and preventing irrationality when the pressure is on.
Fund manager decision-making
Just like everyone else, fund managers are emotional beings. Therefore, we need to have measures in place to ensure that we remain rational when those dark clouds gather and market sentiment strikes emotional chords.
How do we do this? Through a strong decisionmaking framework.
For example, how do we approach a situation in which a company that is held in our funds falls out of favour in the market due to industry or company-specific challenges?
It is at this point that we run our checklist:
ý Is the management team’s integrity still intact?
ý Is it still making sensible capital allocation decisions?
ý Is the company’s competitive advantage intact, generating satisfactory returns on capital?
ý Does management have balance sheet wiggle room?
ý Is the share pricing in an extremely unlikely scenario?
The drastic sell-off in resource companies and South African financial companies in 2015 are prime examples of when we had to rely on our checklist.
Investor decision-making
When it comes to the decision to remain invested or exit a unit trust, the investor can drill down to his/her own set of questions:
ý Does the asset manager in question have a long-term track record of outperforming benchmarks?
ý Is the asset manager remaining consistent to its investment philosophy?
ý Is it clearly communicating the reason for poor short- and medium-term returns? ý If not, why not? Good reasons for sticking with your manager despite a dip in performance should be evident from its communication with you. These may include:
ý If it is acting in a contrarian manner (opposite to the market herd), which is inflicting short-term pain for long-term gain;
ý If there is a prolonged dislocation between the price of shares in a company versus what it is actually worth, generally due to fears that are exaggerated due to emotion or market participants not fully understanding the nature of the business.
However, if poor short-term performance was due to portfolios being too highly correlated (ie containing concentrated bets) or multiples normalising (indicating that your manager was invested in over-valued securities), be cautious of continuing your support.
Ideally, all investment decisions should be grounded in the logic of probability.
This is possible if we follow a decision-making framework rather than acting on emotion.
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