How to have an Investment Edge

Want to make more money than your peers in the stock market? Learn to ignore your behavioural biases - the human nature flaws that encourage bad investment practise

Emma Wall 23 May, 2014 | 7:30AM
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This article is part of the Morningstar's Guide to What the Experts Say. Click here for our edit on what the professional investors think about economics, equities, bonds, financial advice and portfolio construction.

Emma Wall: Hello, I'm Emma Wall. I recently had the chance to talk to Michael Barakos of JPMorgan on how behavioral bias influences your investment decisions. Here is what he had to say at the Morningstar Investment Conference. 

So what exactly is behavioral bias and how does it influence people's investment decisions?

Michael Barakos: Well, behavioral biases are – there are plenty of examples and they're around in everyday life. Before you even start to think about the investing world, they're in the real world. We're human beings. Human beings are not perfect. They are emotional. They have personalities, they have different personalities, so different people tend to be prone to different behavioral biases more so than others.

The key reason why it impacts investment decisions is because whenever you let your emotions get in the way of taking a clear view of what's the right decision based on the facts, you tend – not always, but you tend to lead to suboptimal decision-making.

Think about investing and go back over the last decade or so, think about the euphoria during the TMT bubble, the euphoria during the credit bubble, people buying in at very high levels, think about the doom and gloom, the panic at the end of the TMT bubble bursting or at the end of the global financial crisis – if I dare say we're at the end of it, or at the end of the Eurozone crisis. Now people panicking and selling pretty much at low.

So it's really important to control behavioral biases such as herding mentality, fearing sticking your neck out against the herd because it feels emotionally uncomfortable. Even though you may mean you're right, you're very lonely for long period of times some times and that can feel uncomfortable and no one likes being unconventionally wrong. So herding is a behavioral bias that can lead to suboptimal investment decisions.

Regret aversion can as well. We don't like admitting we've got it wrong, we've made mistakes. But humans make mistakes all the time in the real world. They make mistakes all the time in the investing world. We have to try to learn from those mistakes and try to not make them again in the future, but you've got to be realistic. You can't have an ego, you can't have pride. There is no room for those things when it comes to success for investing.

You've got to put your hand up when you get it wrong and move forward.

Wall: One way that you can successfully be a contrarian investor is by focusing very simply on valuations, isn't it?

Barakos: Sure, sure. I think valuations don't necessarily predict what's going to happen today or tomorrow. But they're in my opinion and from everything I have seen the most powerful investment criteria to look at amongst others when you're looking at investments over the medium to long term investment decisions. So three, five, 10 years out, because often when valuations are very cheap and hence typically is a good investment opportunity, there is typically a lot of bad news, a lot of bad story telling associated with that investment.

Hence emotionally, it's very difficult to again stick our neck out, go against the herd, be mentally tough and take the tough you at the point which with the benefit of a hindsight will be obvious, but at the point it’s difficult.

So valuations I think are the best guide to investments over the medium to long term. When you buy investments cheaply, time and time again it's proven over many decades, you tend to generate above average returns for that asset class or that equity region for the next three, five, 10 years and vice versa. When you buy investments expensively, you tend to – you may not get quite at the peak, but you tend to get below average returns for that investment over the medium to long term.

Wall: And one of the things that you mentioned is 15, 20 years ago the way that investors got an edge over their peers, over their competitors, was having information that other people didn’t have. Unfortunately this is no longer the case especially with developed markets. There is just so much information out there, public-listed companies, the internet. How does an investor get an edge now?

Barakos: Sure. I think it's such an important point. What it means is it is a much more level playing field, much more competitive honest game. Technology has meant that the average individual investor can access real-time information just as a professional, supposed expert or institutional investor can. Regulation as well has changed so much in the last few decades to make sure that the average individual investor is rightly protected versus the big institutional investor.

So, the edge isn't in the access to the information anymore, the edge is in how you analyse that information. Can you – do you have the skill to probably, as you alluded to, probably ignore the majority of information which is noise that have the skill to identify what is the relative information factually, objectively, and are you willing and able to learn and evolve the way you think about investment decisions, which again sounds obvious, but isn't necessarily easy for human beings to do.

Wall: Michael, thank you very much.

Barakos: Thank you very much.

The information contained within is for educational and informational purposes ONLY. 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. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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