Reason is probably one of the biggest distinctions between humans and animals. It has given us the ability to learn from different circumstances and to adapt over time. These lessons sit deep in our subconscious minds and instinct / emotions /intuition allows us to react quickly without having to reason ourselves out of every situation, especially if time is of the essence. We are also creatures that like to operate as part of a group and therefore tend to look for guidance from the majority of the herd. This all makes sense and is part of what has allowed humans to evolve and survive over time. However, intuition (even though not necessarily inferior to reason) is the “lazy” part of our brain and sometimes this lazy thinking can cause us to take suboptimal decisions driven by emotions or irrational herd behaviour.
The herding behaviour drags our emotions up and down the roller coaster of economic cycles with the result that we are often overoptimistic when things go well and overpessimistic when times are trying. It is as though we suffer from Alzheimer’s as we mostly remember the good memories and easily forget the difficult times of the past. It is striking how rational we tend to be when it involves comparing prices in a shopping mall and how irrational we can be when it comes to comparing prices of investments. This often leads to emotional behavior that causes people to think that when things are going up (perceived safety), it will continue to go up and when things are tough it is all doom and gloom and prices will fall indefinitely (perceived danger). The result is that we buy high and sell low, exactly the opposite of what reason would suggest. Making an investment into a good asset when the price is low is probably the safest time to invest.
At IJG we realise that we are human beings subject to the same pitfalls. We therefore make use of a risk management framework that helps us to stay more rational through cycles:
Volatility (things moving up and down) and probably best described through stock markets, tend to fuel irrational behaviour. Markets reward investors who are willing to take on more volatility through higher potential returns. What we have learned is that we can dissect clients’ overall dreams into more tangible objectives. Once we have done this, we can match time horizons of those objectives with the time horizons required by different investment solutions and therefore optimise our ability to take advantage of the return rewards of volatility.
Permanent loss of capital is probably the most important risk that one needs to consider. We believe that the probability of making a permanent loss of capital increases in the following 2 instances:
(1) No adequate diversification is a concept that most of us are familiar with through phrases like “don’t put all of your eggs in one basket”. This doesn’t mean that one needs to have 10 different funds or wealth managers or even need exposure to different asset classes (investment solutions). Rather, the identified objective’s associated time horizon will guide you to choose the applicable investment solutions needed and within those solutions one should diversify. For example, if you have more than 7 years as your time horizon, equities could be a great asset class to consider, but it could be wise to have for example 30 stocks diversified over different geographies. If an unforeseen event takes place, you haven’t lost the farm.
(2) Paying more for something than what it is worth is often a stumbling block for most, as the emotions described above, can cause people to pay more for something than what it is worth when things are great and selling something for less than what it is worth when times are tough – irrational behavior. The property market in Namibia is a great example of this principle.People were swept up in the hype of the property bubble (over valuation), and when the economic cycle turned, pessimism caused prices to fall along with the increases in vacancy rates leading to forced sales and ultimately permanent partial losses of capital. Even if people overpaying were to wait for the cycle to turn, they most probably will still be making partial permanent losses of capital due to time value of money (inflation and opportunity cost).
If we are honest with ourselves, we must admit that the world is full of binary outcomes that we could never accurately predict on average. Constructing a portfolio around binary outcomes will result in you chasing your tail and paying brokers unnecessary trading fees. How easy was it to predict that Trump would be president of the biggest economy in the world, or that Ramaphosa would become president of South Africa? These things are often not that important to predict. What is important is that you understand what you want to achieve (broken down into tangible objectives) and decide what investment solutions will match your objective’s time horizon. Thereafter, you can sit through volatility and protect the permanent loss of capital as you compound over your investment horizon by being adequately diversified and always paying the right price.