Stockpicker’s psychology

There is perennial debate about whether stock selection improves investment performance over the long term, compared with the lowcost, low-effort approach of simply buying index products.

At the heart of the debate is the question not of whether some stocks in the index will do better than others – this will always be the case – but whether those that will perform better can be reliably selected in advance.

Over short holding periods, this is always doubtful at best. There are simply too many idiosyncratic and unexpected events that can lead any one “good” stock to disappoint over any specific short time horizon.

Furthermore, in the turbulent risk-on, risk-off markets we have experienced since August, picking individual stocks seems to have little discernible effect, as markets rise and fall as a whole, led by changes in political events or investor sentiment, whose effects are common to all stocks.

However, this high volatility, high degree of focus on short-term newsflow and lack of discrimination between individual stocks provides an environment potentially full of opportunity – that is, for those with the emotional resilience to stick with investments through the turmoil.

This is true both with respect to the level of the market as a whole and also for purch-asing individual stocks at particularly good long-term value.

In fact, it is the very anxiety induced by the market turmoil that brings the first source of value. Stressful and uncertain times tend to shift investor focus to excessive concern about what will occur in the short term and away from calmer reflections on long-term value opportunities.

Emotional time horizons shorten and this enhanced nervousness naturally causes investors to shun investing more than if they were taking a more rational long-term perspective.

An emotionally induced lack of demand for risky investments drives markets lower than can be justified by a less myopic evaluation of risk and return.

In other words, long-term and emotionally resilient investors can take advantage of the temporary anxiety premium caused by the high level of stress, fear and myopia of everyone else in the market.

This is not to say markets are not still risky but in times of stress, markets are not only pricing in risk, they are also pricing in the emotional anxiety of all those investors who have taken their eyes off their long-term investment goals. Unless we think markets are significantly underestimating the true risks, then times of turmoil are good entry points for long-term investors.

But what about individual stock selection? Another feature of stressed investors with myopic emotional time horizons is that their perspective becomes much less nuanced – fearful investors often flee risky assets as a whole, without discriminating effectively between high and low quality assets. Correlations increase and all stocks move up and down together, depending on whether the prevailing sentiment is risk-on or risk-off. When markets fall, investors sell the good with the bad.

This means not only is there an anxiety premium for the market as a whole but good stocks can be dragged down with all the rest, despite very robust long-term prospects.

As a result, at times when stocks as a whole are being shunned, there can be a number of hidden gems available at good prices for those with the knowledge and expertise to unearth them.

In the short term they may well continue bouncing up and down with the market as a whole but a basket of such shares, carefully selected, allows investors to supplement their portfolio with assets purchased at deep long-term value, at a time when most market participants are more concerned about short-term emotional comfort.

Greg Davies is head of behavioural and quantitive investment philosophy at Barclays Wealth