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Investment Strategy View: Investor Emotions

Investment Strategy View: Investor Emotions

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Patience Is A Virtue

It has been no secret that markets have been on a tear over the last 18 months or so. What started as a contrarian rally has turned into a rally thoroughly embraced by the masses, underpinned by excitement over the emergence of artificial intelligence. Only the staunchest of bears remain skeptical of this rally, though there are some nuanced takes out there.

One of the more common concerns regards valuations: Is it a bad idea to invest or be bullish when price-to-earnings (P/E) multiples are at relatively high levels? The short answer is not necessarily. Important context can be missed when relying on P/E ratios alone. For instance, a relatively high forward 12-month P/E could indicate a stock is expensive, but it might not necessarily be expensive if you adjust for medium to longer-term growth expectations (i.e. the P/E/G ratio).

More broadly, a common investing adage is that valuations are not a good timing mechanism. And if seeing is believing, just look at the following scatterplot that shows 1-year returns (blue) and 10-year returns (magenta) at different P/E’s. Blue dots are everywhere, indicating many different short-term return possibilities for any given P/E. But magenta dots are tightly packed, which suggests some predictability on longer time horizons.

There really isn’t any pattern to what kind of return you can expect to get in the short-term, but as you start to look longer-term, the negative relationship between forward returns and valuations becomes more robust. Unfortunately, it’s hard to tell exactly when a drawdown might start, and just staying out of the market forever while waiting for one isn’t exactly the right move either. After all, you could end up waiting a while.

Managing Emotions

Investing can be tough. There’s basically an endless amount of information you can consider when crafting a thesis, and that’s before considering the behavioral side of things. We’re not robots. We’re not homo economicus, aka the rational economic man. We feel. We react. It’s hard to digest every piece of information we’re bombarded with. Sometimes we overreact, other times we underreact.

An example of a behavioral quirk that manifests itself in investing is called the disposition effect. In essence, it refers to the tendency investors have to sell their winning positions too soon and hold onto their losing positions for too long. The following chart shows what this dynamic looks like.

While it’s not clear exactly what drives this phenomenon, one possible explanation is that people generally exhibit what’s called loss-aversion bias, a tendency to prefer avoiding losses versus pursuing equivalent gains. This is an extreme example, but if you had a house or car, would you risk losing it for an equal chance at winning a second? Probably not.

Letting Your Winners Run

Part of investing is trying to keep these sorts of emotions in check. While some might be skeptical of further gains in today’s market or think we’re “due” for a pullback, history suggests that the strong performance we’ve seen can continue for longer than we may think is likely.

The poster child for strong recent performance is the Nasdaq 100. It has been a key beneficiary of the AI theme due to the high concentration of the largest tech companies, gaining more than 80% since the start of 2023. Since 1985, there have been six other similar periods with at least 80% returns over a 2-year period. During those instances, the Nasdaq 100 averaged an additional 14.1% the following year.

History suggests slightly lower returns after a strong two-year period, but not that much lower. Return expectations decline more meaningfully as you lengthen your horizon, but the same applies here as it does for valuations: Information like this is not a great market timing mechanism, with momentum in markets sometimes taking a while to dissipate.

It’s easier said than done, but the solution to loss-aversion bias is for investors to sometimes go against their gut. Periods of volatility can be unsettling, which reinforces the importance of evaluating the market backdrop as objectively as possible. Have things changed? And if they indeed have, have they changed enough to change your investment thesis? If not, the best move might be to let your winners run.

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