While market trends like the emergence of artificial intelligence (AI) may have swept up investors around the world, as seen with the meteoric rise of Nvidia in 2023, investment managers remain wary of falling into the emotional decision-making ‘trap’.
Appearing on an upcoming episode of the Relative Return podcast, Merlon Capital Partners’ Andrew Fraser explained that an understanding of humans’ behavioural biases, like an aversion to risk and a desire to exploit short-term market trends, can be a valuable asset in portfolio construction.
“Our philosophy is centred on behavioural bias, and we sum that up in a statement that we believe people are motivated by short-term outcomes, overemphasise recent information, and are uncomfortable having unpopular views,” the portfolio manager told InvestorDaily.
“These are not unique to Merlon per se. They are well researched, well-documented behavioural biases, but we believe they exist even in the advent of AI and so forth.”
In the case of Nvidia, investor interest has lifted its share price by 49.7 per cent year-to-date, making it one of the best-performing stocks on the S&P 500 Index so far in 2024.
It had been among the less-discussed picks of the AI wave, but following the release of its quarterly earnings back in May and rising demand for its data centre chips, Nvidia’s market value crossed $1 trillion at one point and rose threefold.
Mr Fraser explained: “If humans are involved in the economy, in markets more broadly, these behavioural biases will exist through time. And that’s what we’re trying to exploit – common things around fear and greed, that people overemphasise recent information. So, we look at what happened in the last six months and project that out, quite often too far into the future.
“When you look at the likes of AI and the share price performance of Nvidia, that could be a good example where maybe the expectations of the market may not be fulfilled by the earnings of the company, notwithstanding what is arguably a huge opportunity or growth area in technology going forward.”
Explaining the firm’s investment philosophy, Mr Fraser elaborated: “When we talk about people, it’s not just us as investors, it’s broader than that. We think about people, whether it be company management teams and boards that may make poor capital allocations, sacrificing long-term shareholder returns to generate a short-term blip in the share price, procyclical capital allocation.”
Given the world is headed in the direction of decarbonisation, he pointed to investors’ drive towards green energy stocks and how investment managers, like himself, have attempted to navigate behavioural biases in stock picking.
“Everyone’s well aware of the push to decarbonise the electricity system, and you’ve only got to look at the volatility in lithium stocks as an example of that, where the push to move into lithium might be great for your green credentials but is it right for generating acceptable shareholder returns?” he said.
“We’re exposed, as any investor, to these issues, and we’ve designed our business structure, our process to try and limit our exposure to those behavioural biases so we don’t fall into the same traps.”
Betashares director Ele de Vere has previously discussed how emotions can affect investment decisions in what has been described as the cycle of market emotions.
“In a rising market, our optimism, and the excitement of rising values, can lead us to think that we will continue or start making gains easily. Fuelled by feelings of hope and greed, we may increase our level of risk just when prices have already risen significantly, investing more at precisely the time we should be cautious,” she said.
“Conversely, when markets are falling, we may be presented with strong buying opportunities. However, anxiety, fear and panic can prevent us from investing, and in some cases, are enough to drive us to exit the markets – at precisely the wrong point in time, when prices are at lows.”
Looking back at previous market cycles, she noted examples in the 2008 Global Financial Crisis all the way back to the Dutch tulip bulb market bubble in the 1630s, when the desire to own tulip bulbs drove up their value to extremes, and at their peak, they traded for as much as six times the average person’s annual salary.
“By understanding this cycle of market emotions, we may be able to better take advantage of investment opportunities while potentially mitigating risks,” Ms de Vere said.
Last year, Morgan Stanley Investment Management’s head of the international equity team, William Lock, and analyst Annabel Stanford, remarked the AI wave would, once again, test the ability of investors to ignore the “euphoria of a market bubble”.
“Avoiding the growthier, more speculative stocks that rallied during the dotcom boom, and instead holding steady with an overweight to consumer staples (which had been significantly lagging), paid off in the ensuing dotcom crash that began in March 2000 and ended in October 2002. The MSCI World Index fell 43 per cent from the peak to the trough, while the more defensive consumer staples sector rose 17 per cent in this same time period, finishing ahead of the index,” they explained.
“Arguably, enthusiasm around artificial intelligence is testing some investors again today. Our focus on established, quality companies with earnings resilience, and the discipline to resist the urge to chase a short-term rally, has historically resulted in a better long-term outcome.”
