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Great expectations

The first edition of VFTD was published in April 2012 and this month marks the 70th time we have sat down together, compared notes and decided what we would like to write. Our ‘library’ of past issues has increasingly become a useful reference source for us and our attention this month was drawn to edition 49, titled Shakespeare in the Twittersphere. Our link here, we must confess, is somewhat tenuous, insofar as it is another great British writer to have inspired us this time; instead of William Shakespeare, we have turned to Charles Dickens and his novel Great Expectations.

The story – first published in December 1860 – introduces the reader to a host of memorable individuals such as Mr Jaggers, Able Magwitch, Miss Havisham and Estella; all of whom influence the life of the central character, Philip Pirrip, otherwise known as Pip. The period of the novel was a time of change; England was expanding worldwide and becoming a wealthy regional power. The economy was changing from being based around agricultural, to one driven by industry and global trade. With increasing technological advances came clashes with religion and rising social problems, particularly in terms of inequality and the fear ‘machines’ would lessen the need for workers.

Based on this very brief overview, there are clearly some familiar parallels with today. However, putting these aside, it is two life lessons learned by Pip as he matures from a boy to a ‘gentleman’, which currently resonate with us as investors.

So, what are these lessons?

The first might best be summarised as ‘appearances may be deceiving’. Many of the people Pip meets through his story are not what they first appear to be. Estella, Pip’s love interest, for all her beauty, is actually cold and heartless; as is Mr Jaggers, the lawyer. Conversely, Magwitch, the on-the-run convict Pip begrudgingly helps as a boy, is actually very kind and later shares his future good fortune and wealth with Pip.

When what we think, expect, or do is not consistent with other beliefs or actions, we exhibit a human behavioural bias, termed cognitive dissonance. This is the mental stress or discomfort we feel when having to act in a way that is contradictory to our belief system, or being introduced to new information that is thoroughly the opposite to what we previously believed. Put more accurately, cognitive dissonance is a feeling that things just don’t add up – either two beliefs are inconsistent, our behaviour is inconsistent with a belief, or two behaviours are inconsistent. Think about Pip falling in love with the beautiful Estella, initially ignoring – but ultimately accepting – she is not a very likeable or lovable woman.

Cognitive dissonance becomes increasingly problematic the more experienced and influential we are. In these circumstances, cognitive dissonance exhibits itself where dissenting evidence is reframed or, potentially, ignored. All the members of Affinity’s investment team have recently read Matthew Syed’s bestselling book, Black Box Thinking – Marginal Gains and the Secrets of High Performance, which addresses some of the dangers associated with this behavioural bias. The major takeaway being the more senior you are and the more you have your opinions expounded, the more likely you are to cling to “what you believe”, even in the face of overwhelming evidence to the contrary.

Looping all this back to financial markets, the chart below welcomes us to the world of ‘the fully invested bear’.

This is taken from the monthly and commonly referenced BoAML Fund Manger Survey (FMS) and plots the net percentage of fund managers believing equities are overvalued (the blue line) alongside the average cash positions in portfolios (the yellow line). This is a classic example of cognitive dissonance in action; look how cash levels are falling and being used to buy equities which the purchasers clearly believe – and are choosing to ignore – are excessively valued. Going back through time, you can see the last period this behaviour was so pronounced was in the late 1990s, ahead of the bursting of the TMT bubble.

The second important life lesson for Pip centres on the “dangers of being overly influenced by others and the need to be true to oneself”. In his efforts to move up in society, Pip wishes to socialise with Estella and other gentleman; but in doing so, is described by Dickens as becoming snobbish. Pip loses friends as a consequence and, only once he realises how cruel a person he has become, is he able to avert the further loss of important friendships.

Being overly influenced by others, in investment terms, typically results in following the herd and finding oneself in ‘crowded trades’. This next chart is taken from the same survey and illustrates the net percentage of asset allocators stating they are currently overweight equities. The pale blue bars show a crowded investment community, where the majority have their portfolios ‘pointing’ in the same direction (i.e. long equities). To compound matters, the survey asks contributors to state when equity markets will peak and a staggering 70% believed it will end some point this year. In other words, we have to assume the vast majority of these overweight investors believe they can ‘time’ when to reduce positions ahead of this fall.

Notwithstanding the comments made above, the thing that resonated with us most about the book, is the title itself; Great Expectations. The tension throughout the novel is one that is common to all of our lives, the emotional struggle that; what we have been given is insufficient, we should always strive for something better and have great expectations of a more fulfilling future.

Expectations about the future are something all investors have to consider as they commit capital to financial markets. Forecasting the future – as we have written many times – is extremely difficult, however, there is one investment firm which made a stunningly accurate forecast, nearly twenty years ago. This earned them an enviable reputation, still very much held today. The firm in question – GMO – made a forecast in Dec 1999 that the annualised real return from the S&P 500 would be -1.9% over the next 10 years. Remember, this was at a time when TMT stocks were rampant and every investor was confident they would make – or had already made – a small fortune from investing in the US equity market. GMO were true outliers in their views and one of the founders, Jeremy Grantham, recounts the stories of the many mandates, lost to competitors, given their outlook; cognitive dissonance at work. Over the next decade, the actual annualised return from the index was -3.5%.

What are GMO’s forecasts today?

Take a look at the chart below. They do not portray an attractive investment landscape, with the majority of the equity sectors analysed forecast to deliver negative annualised returns over the next 7 years. Should these prove to be anywhere near close, then many investors could be facing significant capital erosion.

7-Year Global Real Return Equity Forecasts Source; GMO, 28 February 2018

Implications for portfolios Before panic sets in, we should point out this is precisely why you employ an active manager, who can seek out the pockets of value – e.g. emerging markets – and avoid the crowded trades. Having no strategic asset allocation means we don’t have to own things we don’t like. We employ realistic, not great, expectations; direct capital to the current opportunity set, seek alternative returns and, above all, are patient.

Julia Warrander and Russell Waite

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