23 May 2021
Quality investing means buying and holding a portfolio of quality companies. In Part I of our recent White Paper on the subject, we look at the reasons and influences behind quality stocks’ performance. One of the explanations comes from the area of behavioural psychology. The behavioural biases of the ‘average’ investor can drive performance patterns that create opportunities for more rational and astute market participants.
Six of these behavioural biases may influence how quality stocks perform – we list them below.
Investors might have too much confidence in their own skills. They may be prone to believe that their expertise will be best rewarded by selecting riskier stocks. Among these could be companies with seemingly greater earnings upside potential. Such potential could be accompanied by higher leverage and more variable earnings, however. This might leave higher-quality, more stable companies undervalued, thereby offering higher returns.
Company management teams are also prone to overconfidence. They may, for instance, overestimate future growth, guiding the market or even booking profits too bullishly – and investors may fall for these projections. When the actual earnings fail to match expectations, the stock price may fall.
When it comes to lotteries, people have a tendency to focus on the size of the reward. The larger the jackpot, the more we are willing to ignore the high chance of losing. This gambling behaviour may lead investors to over-pay for stocks with lottery-like payoffs: typically lower-quality stocks that may ultimately disappoint.
Human beings have a tendency to favour near-term rewards. Present bias means we are likely to overvalue the potential short-term benefits of low-quality companies because they have the possibility of a higher near-term payoff. This means we might undervalue the long-term benefits of quality companies.
“Human beings have a tendency to favour near-term rewards.”
Humans also tend to attach more importance to recent events. Investors might focus on earnings reports, corporate news and the latest economic data. This can lead them to undervalue long-term profitability.
As always, incentives matter. Some professional investors are incentivised to generate strong short-term performance. They may hope to raise a large amount of assets – or perhaps rescue their career. Others profit from performance fees based on one- or three-year returns. These investors may overpay for volatile stocks with the potential for the highest near-term payoffs.
To prevent our biases adversely affecting the decisions we make, we must understand them. We cannot remove them, but we can build more systematic processes to overcome their negative influences. With this understanding comes the potential to profit from the biases of others.
By adopting a systematic approach to quality, investors can take the other side of the trade to those succumbing to these biases. Investors in quality companies focus on long-term potential, not near-term rewards, and on predictable earnings, not volatile share prices. In this way, a quality approach has the potential to profit from the irrational behaviour of the average investor.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.