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Chris Gilchrist: Investors, shoot your inner sheep

In the 1970s, an investor couldn’t diversify an equity portfolio unless they had around £100,000 in today’s money, because there were no index funds. Instead, we had paper share certificates, stamp duty and high dealing costs. And buying actively managed funds was more costly than buying shares.

Risk in that era meant not the geeky volatility of modern portfolio theory, but the possibility of a permanent loss of capital. The bankruptcy of the original Rolls-Royce business in March 1971 reminded everyone of that.  Because the FT Index, composed of 30 blue-chips including RR, was a geometric index (multiply the prices of all constituents and take the 30th root), the index plunged as RR shares tanked. Any zero in the multiplication series would result in zero for the FT Index, and if the FT had not briskly removed RR from the index, it would have gone to zero.

Able to buy only a few individual shares with a small capital sum in the 1970s, investors had to regard sudden share price falls as harbingers of doom – even if, in most cases, they weren’t. Their best policy was to sell to avoid the possibility of total capital loss.

Today, cheap index funds mean you can have a world-diversified equity portfolio with hundreds of individual shares within it for £1,000. Investors don’t have to think about volatility of share prices in individual companies. Instead, they look at market trends, which makes some sense, and economic forecasts, which makes no sense.

First, the forecasts are always wrong – it’s just a question of how wrong. Second, there is no relationship between economic performance as measured by GDP and equity market performance.

Watching market trends has turned most investors into trend followers or momentum investors, both of which are grandiose names for sheep. I encourage you to watch sheep. One takes a step or two this way, then another goes the other way, so the rest stop. Then one or two follow the first sheep, which speeds up when it knows it has followers. That encourages more to join in until most of the flock are running towards… what?

Small factors have big effects on the movement of sheep. They are sensitive to flock behaviour. They don’t want to be out on their own.

Investors today are over-sensitive to random short-term changes. The wide diversification of their equity investments means this volatility has no meaningful implications regarding future returns: the messenger carries no message. Yet investors buy and sell merely on the basis of this volatility.

In today’s farmworld, behaving sheepily has no adverse consequences. For investors, though, buying and selling in response to random volatility does have bad results: the data shows average self-directed investors’ returns are below the market average, because of their trend-following behaviour. And don’t think for a minute that professional investors and advisers are immune from sheepiness. Shoot your inner sheep.

Chris Gilchrist is director of Fiveways Financial Planning

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