The Fed’s rate hike last week is another sign that we have entered a new regime and further market volatility may lie ahead.
Avoiding investor distortions in times of volatility
We think that justifies it Think carefully about behavioral biases, as these unconscious influences on investment decisions are amplified by volatility. We look at three prejudices and what to do to avoid them:
1) Inertial preload
First, inertia, an aversion to change or just small, insignificant changes – can become costly now if your portfolio is still positioned for the previous regime.
2) Disposition Bias and the Endowment Effect
The reluctance to rotate out of losing positions or add to them mechanically, to take more risks to avoid the pain of a loss, is the tendency to disposition. Another bias to consider is the endowment effect. It’s when investors keep assets they wouldn’t buy today.
3) Three methods for reducing bias
So how would we avoid bias?
First, imagine that you have realized all your wins and losses. Then construct the ideal portfolio. Don’t abandon your investment process, move away from small changes anchored on status quo stocks.
Second, think about future market events that signal when to take profits or cut losses. That’s why our half-year outlook shares the signposts we’re looking at.
Finally, be open about bias and allow for emotions related to performance and risk-taking.
We take our own advice, revise portfolios to avoid distortions and are willing to change our views on the market.
Investors are strapped into a market rollercoaster ride in a new regime of heightened volatility. Views on central bank interest rates are changing rapidly, as illustrated by last week’s market reaction to the Fed’s rate hike. We believe this warrants careful consideration of portfolio changes. But change is difficult. Behavioral prejudices unconsciously influence investment decisions. We look at three misconceptions that investors might be particularly concerned about in this volatile market — and offer tips on how to overcome these pitfalls.
Pain vs Gain
Notes: The chart shows satisfaction levels from wins and losses relative to a neutral reference point. Black boxes show levels of satisfaction along the risk-taking S-curve—from risk-on (red line) to risk-averse (green line).
The first tendency is the disposition effect, or the tendency to hold losing positions too long and sell winning positions too soon. We expect the disposition bias to be most prevalent when investors are feeling painful losses — like so far this year. Both stocks and bonds have posted declines this year not seen since the 1970s. Behavioral finance finds that people feel the pain of a loss twice as much as they feel comfortable with a corresponding gain (the red versus the green arrow in the chart). As a result, people may hold onto losing positions to avoid the pain of a loss (bottom left of chart). In the meantime, it’s tempting to lock in profits too early with winning positions because one is unwilling to take on more risk for only marginal benefits (above right).
There’s a second bias that should be public enemy number one for professional investors today: laziness. This is a reluctance to make changes, or make changes too small to affect performance. Why is this a problem right now? We believe that the era of steady growth and inflation known as the Great Moderation is over. A new regime of heightened macro volatility is in its place. Still, central banks seem to think they can magically dampen inflation and cause only a slight economic slowdown, as we wrote last week. We see more volatility ahead as markets have rallied on hopes that the Fed will soon change course and ease policy. In our view, this optimism is misplaced. All of this requires professional investors to switch portfolios more quickly. In our view, just following game rules like “buying the dip” or making slow and minimal changes will be costly.
Equipment is the third type of bias to guard against in the current market environment. Think of it as overthinking whether you’ll one day need something that’s been gathering dust for years – when you clearly should be decluttering. People with this bias overestimate their wealth. The longer they own them, the higher the price they charge to give them up. The endowment effect can result in investors holding positions even after an investment strategy has been implemented. This can harm performance. Positions often yield better returns earlier in their lifetime, we find.
Tips for breaking down these prejudices
First, do an empty exercise – imagine you’ve realized all your wins and losses. Then create the ideal portfolio for the most likely market and macro environment over your time horizon. This does not mean giving up long-standing investment processes. Instead, consider portfolio changes without relying on your historical portfolio holdings and results. Second, think about future market events or performance thresholds that signal when to take profits or limit losses. Creating a plan can help determine how to react amid volatile markets and high emotions. For this reason, in our half-year outlook for 2022, we are providing guidelines for rethinking. Third, encourage open conversations about prejudice and the changes needed to overcome it. Discuss your emotions after defeats, investigate mistakes even when you perform well, and weigh the input of colleagues with an alternative perspective.
Beware of behavioral biases when investing. We are wary of their pitfalls because we believe the new regime will require an overhaul of portfolios. We reduced portfolio risk this year. Our latest tactical move: a reallocation of the quality portfolio, downgrading developed market equities and upgrading investment grade bonds. We are underweight US Treasuries and overweight inflation-linked bonds as we believe markets are underestimating the inflationary nature of the new regime.
The Federal Reserve hiked the fed funds rate another 0.75% last week. US stocks rallied as markets concluded the pace of Fed rate hikes will slow, while yields fell on news of faltering growth. The Fed still believes rate hikes will only result in a modest slowdown. It has yet to recognize the stark trade-off between growth and inflation: crush growth or live with some inflation. We do not see a political turning point before 2023 as the data shows persistent inflation. Expect more volatility until the Fed changes course.
This week’s US jobs report is the focus. The report will be crucial as the Fed looks to the labor market for further signs of recovery in manufacturing capacity. The Bank of England (BoE) will hike interest rates again. But we believe it is nearing the point where it will change course. For us, the growth costs of further hikes will mean that the BoE will live with above-target inflation.