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Three behavioral biases that equity investors need to watch out for!

Date : 31/03/2020
Author:  Marmore MENA Intelligence



In a perfect world, all investors would take logical decisions with the markets being priced to perfection. However, this is far from the reality as most investors are much less rational than they think when it comes to decision making. Their irrationality does not relate to a lack of ability, but purely reflects the fact that humans tendto be driven by emotions. These emotions govern everyday decision making of individuals, giving rise to certain biases. When these biases come across to the world of investing, they result in inefficiencies that end up costing investors dearly. Especially during crisis situations, when investors are stressed and resort to panic, even the most logical minds fall back to making the basic mistakes which we would otherwise not make. Therefore, at this juncture where
markets have come crashing down, investors need to be wary of some biases that could potentially result in huge financial losses.

1.    Loss aversion

Loss aversion suggests that for individuals the pain of losing is psychologically twice as powerful as the pleasure of gaining.  In simpler terms, the feeling of fear is much more powerful than greed. When investors see their portfolio value falling by the day, they tend to hit the sell button prematurely to avoid further losses and invest when times are better.



Source: Marmore Research, Reuters; Note: MSCI GCC index is used, KD 1,000 is invested on Dec 31, 2006 close.

  Investment value of KD 1,000 if the investor stayed invested;   Investment value if the investor sells during downturn and reinvests when there is a rally

The above example shows that an investor who tends to stay invested ends up with greater returns than that of an investor who panic-sells in the midst of a crisis and invests later. 
Takeaway – Do not panic! Markets tend to have cycles. Stay invested for a long term.

2.    Recency Bias

Recency bias is the tendency of investors to focus on recent events and extrapolate them into the future.In the process, they tend to forget what happened prior to these recent events. Ignoring information that is old and placing too much emphasis on recent information is one of the biggest mistakes that investors make quite often. When a portfolio’s yearly return is negative during a year, they tend to forget its performance in previous years and expect it to fall further in the next year.



In the above example, U.S. markets had a negative return of 38.5% in 2008, but later bounced back. The 10-year CAGR returns between 2005 and 2014 was 5.4% despite the crisis, suggesting that in a longer time horizon, markets tend to recover and give positive returns. If an investor took out their money after the 2008 meltdown, they would have missed out on the rally that followed. Therefore, guessing the market direction based on recent events would not be a sound strategy.

Takeaway – Do not let recent performance affect your investment decisions. Invest systematically for a longer term.

3.    Overconfidence Bias

Overconfidence bias is the tendency to hold a false and misleading assessment of our skills, intellect, or talent. In short, it’s an egotistical belief that we’re better than we actually are. It is a common thought among fund managers that their performance is either average or above average when compared to passive indices as they believe that they have the ability to assess the market better and take decisions instead of following an index blindly. However, the majority of fund managers fail to beat benchmark returns. The case is similar for most individual investors who believe that they have the ability to time a market. The belief that they could predict the trajectory of future events correctly is a fallacy that results in many investors losing their money. In hindsight, it is easy to point to a level and say that it was the market bottom, but it is close to impossible to predict so with great confidence when we are experiencing it. 

Certain investors overestimate their ability and end up making irresponsible investment decisions, which they regret later. Their rational thinking does not hold good at certain times as the ability of markets to stay irrational for longer periods is higher than the ability of investors to stay liquid. Therefore, it is always smart to adopt a wait and watch approach.



In the above example, there are many instances where intermittent rallies have been bought into by investors. In most cases, they have been led to further declines. As investors tend to jump in earlier than necessary based on their beliefs rather than facts, they tend to get trapped, losing their liquidity and being unable to invest at the right moments. 

Takeaway –Do not try to time the market! Each crisis is new and might play out differently. Tread with caution and wait for a sustained recovery before investing rather than trying to catch a falling knife.

Each crisis is a lesson, but it doesn’t necessarily mean that all crises follow the same pattern. Biases are inherent for humans by nature and could be avoided with utmost discipline. Alternatively, these biases could be removed by eliminating the human aspect during decision making. Robot advisory platforms that use Artificial intelligence and complex algorithms could be the way to go in the future to avoid biases.

 

Tags:  equity, investors

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Institutional investors and real estate portfolios

Date : 15/09/2019
Author:  Muaz Al-Ateeqi

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Institutional investors are the biggest investors in any market. They are the whales of the market and can play the role of market maker, such as; pensions fund, hedge funds, insurance companies, mutual funds and sovereign wealth funds. For such institutions, they tend to look for steady growth, low risk and long-term investments.

The real estate sector is a natural magnet for governmental institutions because it is hedged against inflation, relatively less volatile than other sectors, it is a tangible asset and it provides periodic cash returns.

Institutional investors can diversify their investments within the real estate sector depending on which asset class they want. To do so, they mainly have two entries; through a real estate fund or a real estate portfolio.

The main differences between a fund and a portfolio are:
A fund is a pool of investments, which are converted into ‘units’ or ‘shares’ that are managed by a professional fund manager. The fund manager has full control on the processes and procedures within the fund. The investors buy ‘shares’ or ‘units’ of the fund. Institutional investors generally invest in well-diversified, well managed funds that has a proven track record. 

A portfolio is collection of funds or/and properties that are owned by a single entity. That entity has full control on the policies and procedures to run the portfolio. The main disadvantages are:
  1. All funds are from a single individual.
  2. Governments tend to have a long bureaucratic process, which sometimes lead to waste investment opportunities and decisions.
So, to overcome the government bureaucracy while maintaining full control on assets, institutional investors engage a third experienced party to manage all or part of their assets, this is called investment outsourcing.

Portfolio manager helps in:
  1. Providing the necessary in-depth studies and analysis and recommendations for the owner.
  2. Executing the owner’s vision more efficiently.
  3. Overcoming governmental decision making process bureaucracy through private sector.
Maintaining the value of the assets through an experienced portfolio manager.

Tags:  Investors, realestate

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What are we paying for? - Why investors are fond of the US tech stocks

Date : 01/08/2017
Author:  Marmore MENA Intelligence

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‘FAANG’ stocks, as they are fondly referred, have been the epicentre of the US stock market in the recent past. Technology stocks account for 25.6% of S&P 500, making it the largest sector constituent. Tech stocks fuelled the rally in the US markets in 2017. Apple, Google, Netflix, Facebook and Microsoft with a weightage of 11.1% in S&P 500 index contributed a 34.5% share in the rally of the index in 2017 (YTD).

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Trading at a premium would be an understatement to refer to FAANG stocks as they trade at stratospheric valuations (price to earnings ratio). Analysing all possibilities, we could for sure say one thing, what is driving the valuation is the frenzied investor behaviour of paying too much today for earnings that are likely to accrue in the distant future. So, what are we paying for? – Investor irrationality.

History tells us that investors have similar investment patterns in the past when it comes to US tech stocks. This kind of overexcited investing in tech stocks was the root cause of the catastrophic collapse of the stock markets after the dotcom bubble in 1999. Technology itself seemed to be an impressive business plan for the investors those days. Hence, these tech companies also spent more money on marketing their company to investors. However, markets turned to reality sooner, leading to the crash right at the start of the millennium. Poor financial management, lack of profit generating activities and no vision for the future business pushed investors to realize that tech companies can no longer be their exquisite investments. Many tech firms delisted, closed their offices and some even went bankrupt. In 1999, there were more than 200 companies that filed for an IPO in NASDAQ and vanished after the markets crashed in 2001.

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Analysts who have either given a strong buy/buy recommendation for Amazon estimate that 92% of the price paid is for earnings that would be reaped after 2020(The Economist). In a decade, it is estimated that Amazon would trade at a PE of 10x. Amazon’s customer base is expected to reach 788 mn by 2025 generating a revenue of USD 3 trillion (almost the size of India’s GDP). Amazon’s valuations can be only justified by the exponential growth in its revenue, never with the earnings the company has made in the past nor with that anticipated for the future. Technology is an arena where ten years is too large a time horizon. 10 years before, products that were pioneers in use are no more existent today. With iPhone having being introduced, Apple was forced to kill its one master innovation, the iPod. Nobody thought of cloud hosting and the widespread use of internet two decades before. Technological breakthroughs generally disrupt the existing business models and can change the landscape of a sector/ companies that were till then operating quite successfully. This threatens the basis of estimating earnings for the future, especially in the longer term.

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Net income has never moved in line with the revenues of the company, rather stayed divergent for almost 25 years. The chart above conveys the business model of Amazon, their focus has been to drive down prices and gain market share, which they have quite successfully done in the past three decades. Investors still believe that Amazon is in its nascent stages, and it could turn around to make profits and generate returns for the shareholders. This can happen only if the utopian dream of creating a monopolistic retail and web services market comes true. What would happen if Amazon increases the price of its services when it feels there are no more competitors? This strategy of cannibalising market share by reducing price has never worked out in the long term. The prospect of future earnings cannot happen just by holding market share. For now, Silicon Valley majors seem to have lost ground of their unique proposition – ‘Innovation’, which was at the heart of their organizations when they were incubated.

Similar stories seem to appear on many walls of Silicon Valley. Google and Facebook depend on their advertising revenue to a larger extent. When there is another technological innovation threatening their business, these tech giants have engaged in acquisitions at unimaginable valuations. The large tech companies are unable to innovate new income generating activities in-house, and with a huge cash reserve they have all decided to look for inorganic growth. The classic example would be the acquisition of Whatsapp by Facebook after facing tough competition from Google. The private messenger service ‘Whatsapp’ was valued at USD 19 Bn and acquired by Facebook in 2014. Apple has acquired more than 20 companies in the last two years. It is a qualm if these firms could run for years like these, without innovating in house and focus on profit making activities. Technology has too many competitors to acquire and to enter into price wars.

Snapchat’s IPO listing defeats it all, where the loss making company offered no voting rights to investors and the prospectus stated that it has no intention of paying cash dividends for the foreseeable future. The prospectus states that the company expects operating losses to continue in the future and may never achieve or maintain profitability in the coming years. The company is yet valued at $18.5bn. This displays the passivity of investors towards tech investing, owing which US tech companies afford to lack corporate governance, claim to make losses, deny rights to shareholders, and yet attract investments.

Majors in the Silicon Valley, Apple, Microsoft and Google have been more attractive in terms of their valuations compared to companies such as Amazon, Netflix and Facebook. Product and service line diversification of Microsoft and Apple have generated consistent profits for these companies, unlike in case of the others. Not all tech stocks run similar risks and are not equally overvalued. However, a majority of them, especially those struggling to generate profits are stocks that thrive on the promise of glorious tomorrow.

All said and done, Amazon is just a classic case of fundamentally weak but an overvalued stock. The situation may not be indicating another bubble in the stock markets as in 1999, though nothing much has changed about the way investors have picked companies. In the long run, disconnect between the revenues and the ability to generate profits is a risk that many tech companies have embedded in their business models. Investors have unfortunately failed to take notice of the same.

Bottom line for investors – ‘Look for bottom line numbers before investing’.


 This article is published in "Marmore Blog"


Tags:  Investors, Market, Stock, Technology, US

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