Markets can seem mysterious. Their movements can seem random. But the evidence shows that unpredictability is predictable over the long-term.
A key reason is the behavioural biases of investors themselves. Over the long-term, share prices tend to increase as overall company earnings grow, but the way investors react to market information doesn’t always follow such a rational path.
These biases sway the underlying foundations of the market, particularly when it comes to equities. They are also reflected in a various set of factors (or underlying characteristics) that drive equity performance.
Biased behaviour accumulates into inefficiencies and can be capitalized on via factors that come in and out of favour over different time periods.
Compensated risk factors, such as value (when companies or the market is ‘cheap’ ranked by various measures such as price-to-earnings ratio), and momentum (companies with a rising 6-12-month price), explain the bulk of variability between active Australian equity managers’ performance[1].
There are many other factors that also affect investment returns, such as quality (companies that exhibit stable earnings, low leverage and high profitability) and low volatility (companies with more stable share prices).
Momentum factor driven by investor behaviour
Some factors are driven by the type of rational investment fundamentals that form the bedrock of the industry, while others – such as momentum – seem to contradict them.
Momentum describes the way asset prices tend to continue moving in the same direction, even in the face of new information about the underlying fundamentals.
Evidence shows that these fundamentals are reflected in prices over the long-term, however, investors tend to overreact or underreact to information in the short-term.
It can keep prices trending in the same direction even in opposition to underlying risk-reward characteristics. Evidence shows it is a powerful short-term behavioural bias in the Australian equity market, while another recent study used the unique structure of the China equity market to prescribe it to certain types of investors.
The study compared China A Shares (limited mainly to domestic investors) and B Shares (listed in foreign currencies and traded by overseas investors). While both markets are comprised of the same underlying shares, only B Shares showed momentum as a factor driving returns.
“Consistent with the observation that institutions are more likely to represent quasi-rational investors that underreact to fundamentals, momentum is stronger for B shares with greater (foreign) institutional ownership,” according to the study.
“Specifically, given that retail investors are probably more risk averse than institutions (Haddad and Muir, 2020), we might expect an explanation based on cash flow risk to generate more momentum in the A market. But we find stronger momentum in the B market, particularly for stocks held more by institutions, which prevails after controlling for real options proxies as well as other explanations for momentum.”
Behavioural biases embedded in other factors
The drivers of other factors are not necessarily as clearly driven by behavioural biases as momentum, but behaviour is still a component.
One of Innova’s fundamental investment principles is that valuation (price) drives long term returns – the price an investor pays is the dominant force determining future returns.
Behavioural biases are one reason why stocks sometimes trade below their intrinsic value. Investors can underreact to good news about undervalued assets (value assets can also be perceived as riskier, and therefore require larger rewards as compensation).
Underreaction can be seen through the lens of the conservatism cognitive bias, which is caused by avoiding the psychological pain of changing an embedded belief (and the slow pace of absorbing contradictory, new information).
Low volatility is another factor that has been shown to generate positive returns.
Low volatility stocks can be neglected by investors due to the lottery effect – investors’ tendency to overvalue small probabilities of large gains while undervaluing the much higher probabilities of losses.
If these behavioural biases didn’t exist, markets would always be efficient. Over the long-term, fundamentals tend to come to the fore, but in the short-term, markets can be mispriced, at least partially due to behavioural biases.
Understanding these biases can allow investors to generate more consistent long-term outperformance and hone in on the factors that are in favour during certain market cycles.
[1] Portfolio Insights | Better equity investing | Innova Asset Management. Retrieved from https://innovaam.com.au/portfolio-insights-better-equity-investing.
