Human or cognitive biases can shape our perceptions, our thoughts and our decisions, and at times, may lead us down a path that deviates from logical reasoning.
These biases happen in our everyday lives all the time, yet in the context of financial markets, they can have potential effects on how you invest.
The origin of this concept stem from research around a field of study known as “behavioural finance” pioneered by Nobel prize winners, Daniel Kahneman and Amos Tversky. This research challenged the conventional belief that investors always behaved rationally.
One of the key biases identified was “prospect theory” or “loss aversion’” where losses, in comparison to gains, have a far more emotional impact on an investor.
Consequently, this can change investing behaviour, leading investors to potentially hold on to losers for too long due to the psychological burden of realising a loss. This is one trait with which many of us may empathise.
This, however, is merely the start. Since that seminal research from Kahneman and Tversky, many more biases have been uncovered. From confirmation bias, where we fail to seek out competing theories to challenge our own, to the lottery effect which leads us to overestimate our chances of winning, to herding, which we all saw with the widespread panic of buying toilet paper during covid.
Understanding these biases in detail might lead us to believe that we should easily be able to overcome them and become better investors for it, right?
Well, unfortunately, while we can seek to mitigate their effects, knowing about them doesn’t make it easier to resist them. These biases are deeply ingrained within the human psyche.
However, one of the ways to potentially sidestep these biases is by taking a systematic approach. In other words, use an approach that, to a certain degree, takes out the human and hence the propensity for emotions swaying decisions.
When it comes to investing, the use of a systematic process can potentially help us nullify these cognitive biases. Whilst a version of this can be done by most of us, in Macquarie's view, the true power of systematic investing is using the skill of professional investors.
This is due to systematic investing being a combination of big data, scientific insights and human expertise that seek alpha signals – indicators used to identify investments likely to outperform the market – across the whole investing universe.
For example, a systematic team could process more than 100 million data points a week across a broad range of data sets, which is around 700-1,000 per stock, across nearly 27,000 stocks.
Having access to data is great, but unless you can learn and gather insights from it, it may not help your investing. In addition to having access to data, years of professional investing experience means that market professionals are able to build signals that can indicate whether a certain stock could be a good or bad investment in a way that is not always viable for a retail investor.
From there, a professional advisor can construct portfolios with those stocks by taking above weight or below weight in comparison to the index, all aimed to provide potential alpha, or above index returns.
In Macquarie's view, without a long track record, significant computing power and deep quant expertise, replicating a systematic strategy is near impossible for an everyday investor.
Fundamental research on a stock or a fund on the other hand is much more accessible to everyday investors, even for those new to investing.
When it comes to fundamental analysis, most investors can access research notes, annual reports and, for some businesses, investors can physically interact with their products, to get a direct sense of the product’s potential value as an investment.
Therefore, in essence, investors can, to a degree, be a fundamental investor by doing some form of analysis to inform buy/hold/sell decisions for a stock, fund or Exchange Traded Fund (ETF).
Understandably though, the depth of analysis and skill applied can vary significantly from professional investors to those new to investing.
However, as touched on, systematic or quantitative investing is an approach most investors are unable to recreate due to the scale needed to do it well. To be clear, this style of investing isn’t new and is something investors such as large institutions and sovereign wealth funds have been using for decades across the globe.
There are other differences between fundamental and systematic styles of investing. For example, the concept of “tracking error”.
For those not familiar with this term, tracking error is the difference in how much risk is taken to achieve an investment outcome, which is often the goal of an active manager trying to beat the index.
In other words, a passive or index fund generally has a zero tracking error, aiming to give you exactly the index return. On the other hand, an active fund will generally have a higher tracking error, where they are taking on a certain amount of risk in seeking to beat the index.
When comparing the two investment approaches, in Macquarie's view, systematic investing generally offers more precision around its tracking error relative to fundamental investing.
Macquarie considers that this advantage largely stems from systematic strategies using algorithms and signals that are usually more index-aware than fundamental investing.
As a result, systematic investing often holds more stocks in the index within its portfolios, and in Macquarie's opinion, such a strategy can be more surgical about the targeted returns that it aims to achieve vs the index.
As with any investment, using a systematic investing approach, while offering a more disciplined strategy, does still carry risk, and share markets can be volatile and have the potential to fall by large amounts over short periods of time. One significant risk to note is that systematic investing relies on data and quantitative models that can, especially in times of unprecedented events, present anomalies and overlook the intrinsic value of a stock. For example, the model may highlight potential value for an airline stock during a period like the global Covid pandemic. However, as any astute investor would know, the price of travel stocks during that period were likely to decline due to the uncertainties around if and when travel would resume. This is an example where human oversight of the model results is crucial.
Fundamental investing, by analysing a company's financial health, management quality and market competition, can uncover value not immediately apparent through systematic methods. This is why many investors who utilise systematic strategies also use fundamental analysis when building a portfolio. It is important to weigh the risks of both styles and to refer to the relevant PDS to understand the specific risks that arise due to the nature of the underlying investments before investing to ensure it is suitable for your investment needs.
At a high level, there are three investment style choices for investors to choose from when building a portfolio, though a combination of all three can be used;
In summary, human biases and their influence on investment decisions reveal the importance of understanding and navigating these psychological tendencies.
Systematic or quantitative investing, using data and algorithms, presents a potential way to help minimise those cognitive biases. The evolving investment landscape now offers a wide range of strategies, from systematic to fundamental analysis, offering investors more choice to adopt methods that best align with their investment goals.
By acknowledging our biases and leveraging a variety of investment strategies, investors can refine their decision-making processes to potentially help achieve enhanced financial outcomes.
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