KATHY DAVEY: The deep psychology that drives investing

As humans we are subject to what in psychology is called “negative bias”. What does this mean in reality? Well, if you took a trip to the magnificent African bush and had a wonderful time with sightings of the big five but also had the misfortune to be stung by a scorpion, then you are more likely to remember the scorpion incident than the positives of the trip. This is negative bias in action.

The reason we have this psychological tendency is that as humans we tend to feel the effects of negative events more strongly than positive ones. This primal instinct helps protect us from potential threats. That said, an asymmetric reaction between positive and negative events can be damaging to investment returns when we let the fear of losing money over the shorter term override our longer-term views of equity returns.

If we look at the most recent global market crash brought on by the coronavirus (Covid-19) pandemic, it took only six months for stock markets to recover to prepandemic levels. As the graph shows, the FTSE All World index is now 25% higher than its prior peak, reflecting the returns investors would have missed out on had they panicked and sold out as the market started to crash, and not reinvested soon enough once the recovery got under way.

It is a universal truth of investing that not even the best investors can accurately time markets. It’s not easy to predict exactly how long market crashes will continue their downward spiral or even when and how quickly markets will return to their precrash levels. However, what we do know for sure is that for every equity market crash we have encountered since the start of the FTSE All World index, there has been a full recovery each time. This means the average return for investors over the past decade would have been 8% per year in dollars had money remained invested through the ups and downs.

Equity investing is, by its nature, a long-term project — otherwise it’s just speculation. The best way to avoid the need to jump ship when equity markets get jittery is to make sure you are invested in quality companies that let you sleep well at night. These are companies with low debt levels that operate in industries with high barriers to entry, which may even emerge from adverse economic shocks stronger than before as weaker competitors fall away.

Since the start of the pandemic we have seen an unprecedented response from central banks globally, and the use of monetary policy tools to stimulate growth. Though interest rates in developed markets were already low going into the pandemic, there have been further cuts and the notion that interest rates will be “lower-for-longer” is now widely accepted.

These stimulus efforts work in part because they encourage more risk-taking and low interest rates are generally positive for equities for a couple of reasons. First, lower interest rates reduce the discount rate used to value the present value of a company’s future cash flows, thereby increasing the value of the company. Second, a company’s future profits are likely to be higher if consumers have more money to spend due to lower interest rates.

However, we need to be aware that investors who are discouraged by the lower returns offered by safer asset classes due to lower interest rates may be taking excessive risks or even fall prey to fraudulent activities as they try to achieve higher returns in riskier assets. As indicated in the accompanying graph, retail traders have been growing their share of US equity trading volumes continuously since 2019, when the US federal funds rate peaked, and now account for almost as much equity trading volume as the mutual and hedge funds markets combined.

The lure of stronger equity returns against a backdrop of declining interest rates has no doubt been a factor. However, increased retail activity in equity markets has been further compounded by the Covid-19 pandemic as individuals in many countries have received stimulus cheques and have increased savings due to having fewer activities on which to spend money.

Investing in the stock market is not limited to professional investors. There are different levels of sophistication when it comes to retail investors. However, many retail investors may be less inclined to consider the fundamentals of the companies they are investing in and can often trade on speculation gathered on platforms such as social media sites. In addition to this, retail investors tend not to consider the benefits of a diversified portfolio and may make big and leveraged bets (through options as indicated in the chart below) on individual stocks, putting their future savings at risk as the long-term nature of equity investing is less of a consideration.

For all these reasons, we encourage investors who are looking to achieve higher returns through investing in riskier asset classes (such as equities) to put their money into diversified portfolios, where each individual stock has been chosen for its ability to generate sustainable, compounding returns over the longer term. This requires leaning away from that innate negative bias and letting logic and the insights of history pave the way forward.

• Davey is investment manager at Ashburton Investments.