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Speculation – How to win a losers game

Luke Sheather
Luke Sheather
Posted 13.12.2020 in Investment Planning
Often when I meet someone new and I’m asked what I do for a living, it’s not uncommon for their eyes to light up and for them to ask me what direction I think the market might be headed? Alternatively, it’s what company is going to be the next Amazon?

Questions like these are curious and well-intentioned searches for new ideas. The prospect of gleaning an idea that might lead to easy riches is compelling for most people. It surprises me just how often individuals act on these juicy tips – whether it’s gathered from the gym, workplace or the bar. The temptation to speculate is within many people.

As investors, we must be wary that making investment decisions based on speculation is seldom a recipe for success. Particularly when it comes to investing wealth that will one day be relied upon to support your lifestyle, there are simply better approaches to investing.

The human brain’s thirst for excitement is undeniable. If we speculate and pick a winner, we receive a sense of gratification and accomplishment through the release of endorphins. We give ourselves a mental pat on the back and feel more assured of our ability. It’s when we confuse luck and skill that the problems start. If our original decision was based on a hot tip, then our win should be put down to luck. However, a few lucky wins in a row often creates a sense of confidence and skill, which can be largely unjustified. Nevertheless, it’s these feelings and experiences that frequently lead individuals down the path of active investing.

Traditional active investing involves selecting investments based on a superior forecast, a sense of favourable market-timing or a belief that a security is mispriced. The approach sets out to “beat the market”, with the “market” generally defined as a broad-based benchmark, like the S&P/ASX 200. Individuals can elect to participate in active investing themselves by way of stock picking, or they can engage an active fund manager to make decisions and speculate on their behalf.

As we know, investors have historically been rewarded for participating in capital markets over the long-term. However, unfortunately, for active managers, there is almost no evidence supporting the notion that beating or timing the market is possible consistently.

S&P Global has monitored the performance of active fund managers since the release of their first SPIVA Scorecard publication in 2002. The charts below contain data provided from their most recent 2020 publication and compares the percentage of active funds managers that have beaten their respective benchmark (outperformed) against the percentage of active fund managers that were beaten by their benchmark (underperformed), over varying time periods.

Evidently, active fund managers, more often than not, have failed in their quest to beat the market. The charts above also demonstrate that the likelihood of being disappointed with your active fund manager will only increase as your investment time period lengthens.

These underwhelming results might take you by surprise and make you wonder how is it so many so-called experts get their forecasts wrong?

As Warren Buffet once said, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” And this simple statement underlies the fundamental problem with speculation in that it relies upon a preconceived assumption of the future, which of course, may or may not play out as expected.

An additional feature of active investing which may partly explain the consistent underperformance is that active funds managers are typically incentivised by way of a performance fee if they can attain high returns in the short term. How does one attract higher returns? By taking on more risk of course! Risk that might not be appropriate or necessary for you in achieving your objectives. Inevitably, some active managers will succeed. They’ll hit their return target, receive their fee and those lucky investors will be satisfied with a great performance. But as the evidence suggests, it is more likely that their high-risk strategy will fail, leaving you as the investor in a hole.

The antidote to speculation is to first acknowledge that it is a natural urge – we all want to win. Recognising and appreciating how our brains react to speculation is an important first step. Secondly, we must accept that it is near impossible to consistently beat the market. To overcome the speculation temptation, one should opt for an approach that is supported by evidence and academic research, rather than a “hunch” or a short-term outlook.

Through implementing a strategy that systematically targets proven drivers of return, an investor can take the psychological biases and guessing games out of the equation, and in doing so, give themselves the best chance of achieving their objectives.

Luke Sheather
Luke Sheather
Luke Sheather
As Capital Partners Investment Specialist, Luke does far more than simply identifying and recommending investments, Luke sees it as his role to help clients contemplate and answer life’s big questions.

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