The fund manager's view

Dirk Morris, CEO of BT Investment Management on the outlook for the rest of 2008.

The economist's view

BT Chief Economist Chris Caton on the causes of volatility and where to find the silver lining.

The advisers' view

Three financial advisers on some of the steps investors can take to manage volatility.

The historical view

BT’s Head of Investment Solutions on what history can tell us about future investment returns.

Investor behaviour: that sinking feeling

How do you deal with the emotional consequences of a share market shake-up?

The buying game

For those with a steady nerve, current markets could present some buying opportunities.

The fund manager's view

16/04/2008

Global investment markets have had a pretty shaky start to the year so far as they continue to battle rising market volatility and concerns about the outlook for the world economy. Here, Dirk Morris, CEO of BT Investment Management, takes a look back at what’s been happening over the last few months and what investors might expect over the rest of 2008.

Share markets continue to weaken

It’s been a pretty difficult start to the year for global share markets, with some having fallen as much as 35% from last year’s highs on the back of ongoing problems in global credit markets and increasing concerns over the outlook for the US economy. Just last month, several of the world’s leading financial institutions were forced to announce additional write-downs and credit losses relating to the US sub-prime mortgage market, and there is now some speculation that total losses could rise from around US$188 billion currently to as high as US$350 billion ¹.

At the same time, we’re beginning to see increasing evidence that the US economy is weakening. A combination of rising unemployment and a housing market in perpetual freefall has seen consumer confidence in the US slump to 16-year lows.

What makes this so important, of course, is that the US consumer actually accounts for around 70% of all US economic activity, meaning any slowdown in consumer spending will have a significant impact on future economic growth. So far this year, the US share market is down 9.92% ²  and this has had an obvious ‘knock-on’ effect on bourses elsewhere, including the UK, Europe and Asia.

Unfortunately, weaker global share markets had an adverse effect on the performance of BT’s flagship international share fund — the BT International Fund — which returned -12.58% in the March quarter. Given the current market environment, we’ve now positioned the fund more defensively, with a preference for larger markets that we believe offer good value, such as the UK and Japan.

We’ll also continue to invest less in markets that we consider to be relatively expensive, such as Canada. But I think it’s important to note as well that, in addition to rising market volatility, the strength of the Australian dollar this year has also hindered the returns of Australians invested overseas.

Australian economy holding up

Despite what’s been happening in global markets in recent months, the underlying strength of the Australian economy has remained relatively robust. However, domestic inflation concerns and two interest rate hikes — in February and in March — were enough to push the S&P/ASX 300 Accumulation Index 14.61% lower over the March quarter.

The weakness in the local market was reflected in the performance of our flagship BT Australian Share Fund, which returned -14.43% over the quarter. But despite the fund’s poor returns, it did perform relatively well against the broader market. This is because we’ve invested only in stocks
we believe offer good fundamental value, such as Rio Tinto, Oxiana and Qantas. We believe Rio and Oxiana will continue to benefit from China’s thirst for raw materials, while Qantas, in our opinion, is still very much undervalued by the market.

At the same time, we’ve also avoided investing in highly-leveraged companies and companies exposed to what’s been happening in the US and the rest of the world.

As we move into the next quarter, the Fund’s focus is now very much on identifying those companies that have been sold down on the back of recent market volatility but which we expect to perform well in tougher market conditions.

Listed property funds mixed

Market volatility has had a major impact on the Australian listed property sector lately, with the S&P/ASX 300 Property Accumulation Index falling 19.14% in the March quarter thanks to a combination of rising interest rates and ongoing problems in global credit markets.

We’ve already seen a number of highly-leveraged companies, such as Centro Properties and Valad Property Group, take a hit as banks become more and Global share market performance, March quarter 2008 more reluctant to lend, and this has had a significant effect on investors’ confidence.

Needless to say, the returns from our flagship BT Property Securities Fund were weaker over the quarter, down 18.35%. On the positive side, though, the fund has managed to avoid the likes of Centro and other highly-leveraged stocks vulnerable to the current credit market crisis, and we’ll continue to invest only in companies with low levels of gearing, reliable income streams and good management teams; companies like Commonwealth Property Office Fund and CFS Retail Property Trust.

I think it’s also worth noting that, in our view, we’re probably nearing the bottom in the Australian listed property market and that we still anticipate reasonable medium- to long-term gains from the sector. By contrast, global listed property markets rallied over the quarter — helped by falling interest rates in the US and UK — and this benefited our BT Global Property Fund, which returned 0.48% over the period.

Global bond funds positive

Global bond markets have performed relatively well in recent months, with the inevitable ‘Flight to Safety’ seeing investors offloading shares in favour of government debt. A series of rate cuts by the US Federal Reserve (Fed) has seen US 10-year bond yields fall sharply (prices higher) this year, and this had a positive effect on our flagship BT Global Bond Fund, which returned 4.90% in the March quarter.

With concerns over the outlook for the US economy intensifying, it’s very likely that we’ll see global bond yields continue to fall over the coming months, which should ensure further gains for the Fund in 2008.

In contrast to global bond markets, the Australian bond market has struggled of late, with yields moving higher (prices lower) as the Reserve Bank of Australia continued to raise interest rates to help battle inflation. Our flagship BT Fixed Interest Fund suffered as a result of the weaker domestic bond market, returning just 1.12% over the period, though performance was also hampered by the ongoing problems in global credit markets, which saw a negative contribution from the fund’s credit portfolio.

Diversified funds, which invest across multiple asset classes and which typically come into their own during times of market volatility, have also struggled so far this year. Our flagship diversified fund — the BT Active Balanced Fund — returned -9.43% in the March quarter, with our allocation to international and domestic shares impacting performance. Losses were limited, however, by the Fund’s investments in global bonds and alternative assets.

Where to from here?

With the economic news out of the US likely to get worse before it gets better, we’re undoubtedly going to see further market volatility in the near-term, though recent moves by the US Federal Reserve to lower interest rates should limit the chance of a long-term bear market. The Bank has already cut interest rates three times this year in a bid to maintain economic growth and it certainly appears ready to cut further if necessary.

The Australian economy should remain relatively robust compared to some of its global counterparts, though there are a couple of factors that will determine the direction of the local market in the medium-term.

The first is the impact that any slowdown in the US will have on China. Australia has benefited considerably from Chinese growth in recent years so if that growth begins to slow, it will have an obvious effect on our own market.

The second factor is whether the Australian consumer is able to withstand the ‘triple whammy’ of rising interest rates, higher household debt levels and falling share prices. We think that they can, though the risks obviously remain skewed to the upside.

Here at BT, we’ve stepped up our focus on ensuring that we have the right valued stocks and the right levels of diversification and risk within our portfolios, whether its Australian shares, listed property or fixed income, and we will continue with this strategy in the current market environment.

1_Source: Bloomberg

2_Returns to 31 march 2008. US share market measured by the S&P 500 Index.

The economist's view

17/04/2008

Volatility continues in financial markets, and it’s a gut-wrenching time for investors. As is almost always the case, this bout of uncertainty is coming from the United States, where there are continuing signs of grief in the financial sector.

The latest casualty is Bear Stearns, an 85 year old institution about to ‘disappear’. Readers may remember that two hedge funds run by Bear Stearns got into trouble last June, when the sub-prime mortgage crisis reached a tipping point. Since then, it has been a downhill slide. In January 2007, Bear Stearns traded at US$172 a share. Around 12 March it was US$60; two days later it was close to US$30 and clearly suffering massively from funds withdrawals.

Over the following weekend, another brokerage house, JPMorgan, announced an offer to buy Bear Stearns for just $2 a share. How the mighty have fallen. The Bear Stearns building, in mid-Manhattan, is estimated to be worth about six times the value of the offer for the entire company. That a company can sink so far so fast has naturally increased concerns that there may be other ‘bodies’ from the sub-prime shipwreck about to wash up on shore.

The Fed acts

The US Federal Reserve has acted decisively. In a series of moves, it has dramatically increased the provision of liquidity to financial markets, and it has cut the Federal funds rate (the equivalent of our cash rate), by two full percentage points in just the past three months, the quickest pace of easing in more than twenty years. It also facilitated the bailout/takeover of Bear Stearns, a degree of intervention not used since the Great Depression.

On the day of the rate cut, two other financial institutions that were thought to have sub-prime related issues both reported surprisingly strong earnings and the share market had a great day, both in the United States and Australia. It’s worthwhile remembering that the only time that the US market rises by more than 3% in a single day is when the market is (still) in a declining trend, so it should have been no surprise that more than half of the day’s gains were ‘given back’ the very next day. Message: the day-to-day volatility in markets is not over yet.

The Fed’s actions have been assessed by many as treating symptoms rather than causes, and there is something to this. But the fundamental cause of the loss in value of mortgage-backed securities, which is what is behind all this, is falling house prices, and there is little the Fed can do to hold them up. Concerted action by Congress and the Administration to slow the rate of foreclosures could help, but the main reason why house prices are falling is that they just got too expensive in the first place.
Remember, too, that this is happening in an economy that has entered recession for the first time in seven years. The increasing realisation of this, and the fear that the financial crisis will make the downturn worse, caused large drops in oil, sugar and copper prices. The US dollar continues to fall but, unusually, the $A has fallen at the same time, a victim of risk aversion.

What to do?

So, what’s an investor to do? Let me say first of all that I’m not licensed to give financial advice, so what follows should not be construed as such. First, I’m sure that you wish, as I do, that you (and I) had sold out of the share market at the end of October last year. But hindsight is a wonderful thing, and that’s not the decision facing investors now. Second, as I have written before, the best assumption right now is that the volatility will continue, and that we probably haven’t yet reached the share market low.

That said, the falls have been impressive. The S&P 500 index in the US is down some 15% from its late-2007 peak, while the Australian market is off 20%, with our financial sector down by 23% at time of writing. Our financial sector is, of course, not immune from the troubles besetting world credit markets — it is ironic that the willingness to lend to all and sundry a couple of years ago has now led to a situation in which no-one wants to lend to anyone! But you just have to look at the current dividend yields for Australian banks to conclude that, barring a major accident, they are cheap right now.

If the recession in the US turns out to be mild, then share markets may not have to fall very much further for economy-wide reasons. And there are good grounds for believing that the US recession could be mild, although one can’t safely conclude that it will be until we see improvement in the functioning of the financial system.

What we do know is that, just as share markets always fall during recessions, they also bounce back strongly (beginning before the recession ends!), and investors who move to the sidelines now may avoid further short-term pain, but they may also miss the medium-term gains.

Silver lining?

Meanwhile, there is a silver lining to the cloud. The ongoing market turmoil, possible knock-on effects on the Australian economy, and some signs that the interest rate rises we’ve already had are getting some traction (consumer confidence has slumped, mortgage clearance rates are down) may cause the Reserve Bank of Australian (RBA)) to decide not to raise rates again in May after the next CPI inflation news.

The RBA will be hoping desperately for some sign in the next CPI that will at least enable it to forecast that inflation will fall back to less than 3% some time in the not-too-distant future!

The advisers' view

17/04/2008

The latest round of market volatility may have left a temporary dent on the balance sheets of many investors, but history tells us markets always recover. Unfortunately, history also tells us that panic and anxiety can lead some investors to decisions that create much bigger holes over the long-term. We spoke to three advisers about the strategies they use to coach their clients through the more challenging times.

“I think the seeds to managing market volatility are really sown during the good times,” says Nigel Baker, Principal of WHK Horwath Wealth Management. “It’s really about understanding what you want to achieve over the long term, and putting in place a strategy that will help you do that, regardless of what happens in the market during the short-term.”

For WHK’s clients, Nigel believes the current market volatility hasn’t really come as a surprise. “Of course, everyone would prefer the good times to continue,” says Nigel, “but if you’ve prepared for the tougher times, and you understand that after every boom there’s a bust, and after every bust there’s a boom, then you really should be comfortable with your long-term plans”.

Think long term

Like Nigel, Bruce Smith and Adam Phillips of Westpac Financial Planning are also upfront about the importance of thinking long term, and acknowledge that it can be an uncomfortable experience watching markets turn. “One key element of good planning is the relationships we have with our clients,” says Bruce. “Over the years I’ve done a lot of work around educating my clients as to what to expect with market volatility, so even if they’re a little nervous, they also understand that what’s happening today is just part of the normal economic cycle.”

Adam agrees, and adds that one reason investors come to see them is to seek some reassurance and a second opinion. “A big part of our job during times of volatility is about reassuring investors that the careful decisions they made 12 months ago, or five years ago are still the right decisions today, and that they shouldn’t overreact to short-term fluctuations.”

“One of my clients, an airline engineer, called me this week because he and his wife had become anxious about the markets and the performance of their investment portfolio,” says Adam. “I met with them, we went back to have a look at their original plan and goals and their investing time-frame. By the end of the meeting they were both satisfied that their plan was sound, and had even spotted some new opportunities.”

Stick to your plan

With more than 20 years experience as a financial planner, Bruce has seen some very good times, and some tough times. Regardless of what the market is doing, the message remains the same. “You’ve really got to stick to the plan you set out at the start of your investment timeframe. If your plan was good for you then and your needs haven’t changed, it should still be good for you now.” Nigel agrees, pointing out that investors should take into account all market conditions. “Even if we have clients who need to generate an income from their investment, we’ll make sure they’re boosting their cash reserves throughout the good times, because we know at some stage the markets will get tougher,” he says.

Sticking to the long-term plan doesn’t mean ‘set and forget’. Instead there’s always a requirement to regularly review the specifics of your investment portfolio. “Particularly in the good times, asset allocations will always get out of whack as the growth assets grow faster than defensive assets,” says Nigel. “So, we continually monitor our clients’ portfolios and rebalance if necessary.”

Bruce and Adam also monitor their clients’ portfolios, and try to keep client reviews to just once or twice a year. “Of course, we’re here if our clients want to talk to us, but meeting more than once every six months can put the spotlight on short-term performance, instead of encouraging the client to take a long-term view,” says Bruce.

You can’t time the market

One of the most common mistakes investors make, according to Nigel, is to think they can time the market. “It’s easy to get caught up in the moment, particularly when markets have been so strong for the last four years and investors have benefited from 20% and 30% returns. We see some people taking wild bets about selling now and trying to buy in when the market comes back,” he says. “We don’t believe anyone really has the ability to make those kinds of predictions.”

Instead of trying to time the market, one of the most effective ways of taking advantage of market volatility is to establish a pattern of regular investing. As Adam says, “If you’re investing regularly, either into a managed fund or through regular super contributions, you’re benefiting from dollar cost averaging – or buying more when the market is down and less when the market is up.”

Buy quality assets

Adam also suggests that for younger investors who have a longer investment timeframe, market volatility can throw up some new investment opportunities. “Some of my clients do see this as a buying opportunity – particularly if the market is offering better value now than 12 months ago. Part of my job is to relieve clients of their anxiety, but it’s also important to point out opportunities if quality assets are now at a better price.”

Nigel agrees that sticking to quality assets makes sense. “It’s been pretty easy to pick a winner in the last few years, but in volatile times, you have to get away from speculating. It really does come down to buying quality and sticking with it – history tells us that quality investments always come good with time. And if you’re invested in quality, it’s much easier to sleep comfortably at night.”

Understand how you feel about investment risk

The ‘sleep well’ factor is a big consideration for Adam, Bruce and Nigel, but if one thing is going to change during volatile markets, it’s how an investor really feels about investment risk. “When a client comes to us for advice, one of the first things we do is help them understand their tolerance to risk, or how they’ll feel if their investment goes down, as well as up,” says Nigel. “But in volatile times, an investor’s risk profile can go out the window – it’s our job to get things back on track.”

WKH Group uses a ‘circumstances and attitudes’ profiling tool, which is based on individual circumstances like income and lifestyle to determine an investor’s asset allocation and risk profile. Bruce and Adam from Westpac use a questionnaire style risk profiler and say investors need to take a step back from short-term fluctuations. “Looking back, if you were comfortable a year ago, you should ask yourself why you’re not comfortable now,” says Bruce. “If it’s because you’ve changed your mindset, then you need to think ahead to how you’ll be feeling when the market has recovered.”

A simple tip

When pressed about the one tip he’d offer about investing during volatile times, Nigel is realistic. “It’s not that simple, financial advice isn’t a ‘one size fits all’ proposition. There are so many other variables.” All three advisers do agree that the quickest way to lose money is to let panic and anxiety take over. “It’s well known that those investors who sold out the day after the 1987 share market crash never recovered their money, and those who stayed in, did,” says Bruce. Adam agrees: “If you’ve done your planning and you’re confident about your investment strategy, then there really shouldn’t be any reason to sell now. It’s probably the worst thing you could do.”

About the advisers

Nigel Baker is the Sydney-based principal of WHK Horwath Wealth Management (trading name of Investor Financial Planning Limited) and one of the largest independent providers of financial advice in Australia. Nigel holds a Bachelor of Commerce, is a Fellow of the Financial Services Institute, Certified Financial Planner and Chartered Accountant and has worked in the financial planning industry for 10 years. WHK Group is a principal member of the Financial Planning Association of Australia Ltd, and is a member of Horvath International, an affiliation of independent accounting and financial services firms. Find out more at www.horwath.com.au

Bruce Smith and Adam Phillips are Senior Financial Planners with Westpac Financial Planning, and work together in Brisbane. Bruce started his career with Westpac in 1969, before moving into financial planning in 1986. He now specialises in financial planning for clients who are no longer working, or are preparing for life away from work. As the younger partner, Adam has 13 years experience and is focused on developing long term relationships with a younger client base. He specialises in wealth creation as well as retirement planning, and has an expertise in protected equity loans.  Both Adam and Bruce are Certified Financial Planners.

The historical view

01/04/2008

Since its record high in November last year, the Australian share market has fallen as much as 24% on the back of ongoing problems in global credit markets and increasing evidence that the US economy is headed for recession. Naturally, when the share market undergoes such a significant pullback, investors begin to worry and often ask themselves if they should ‘get out’ while they still can.

But, while all signals continue to point to further market volatility in the short-term, history suggests that remaining invested at times like this may actually be a better option than ‘cutting your losses’ and getting out.

Volatility here to stay

Whether we like it or not, market volatility is here to stay. “Until recently,” says Stewart Brentnall, whose BT Investment Solutions team manages over $2.5 billion on behalf of BT investors, “Australian investors had benefited from nearly five years of relative economic and market stability and the strong investment returns that such an environment brings. “But, as the Australian market continues to evolve and it becomes more and more integrated with other (global) investment markets, it’s inevitable that we’re going to see greater levels of market volatility as a result.”

Some historical perspective

But, should investors really be worried by this? Stewart points to some interesting facts of history. Over the last twenty years or so, there have been at least ten major events that have had a significant impact on the level and direction of the Australian share market, starting with the Wall Street Crash back in October of 1987.

“Each of these events resulted in a sustained period of market volatility. But while these events may have caused great uncertainty at the time, history shows us that the Australian share market inevitably bounced back.” And this, according to Stewart, is what investors need to keep in mind whenever the market is subjected to the sort of volatility we’re seeing at the moment. “Too often,” he says, “investors get caught up in all the hype of short-term market movements and exit the market at exactly the wrong time.”

The long and the short of it

Consider the following two charts. “The first,” says Stewart, “shows the one year returns to 31 December for the Australian share market over a 50 year period from 1957 to 2007. As you can see, over the last 50 years there was a 1 in 4 chance of the Australian share market posting a negative return.”

S&P/ASX All Ordinaries Index – 1-year returns (%)

Now look at the second chart, which shows the rolling ten year returns for the Australian share market over the same 50 years. “You’ll notice that over each ten year period, the Australian share market failed to post a single negative return. Even for the ten years to 1987, which included the famous Wall Street Crash, the local share market still managed to post an average return of 24.4% per year.”

S&P/ASX All Ordinaries Index – rolling 10-year returns (% annualised)

Don’t try to time the market

According to Stewart, a serious mistake that an investor can make is to try to time their entry and exit in and out of the market. “Because the cycles in which investment markets move are not uniform and predictable,” he says, “it’s very difficult to forecast when a particular market will peak or trough. In reality, most of the biggest gains or losses in share markets are actually made in just a few trading days of each year. So, by moving in and out of the market, not only are you incurring additional costs in the form of brokerage and fees, you also run the risk of missing out when significant gains can be made.

According to Stewart, the same is the case if you are trying to pick the best performing asset class. “It often pays an investor to have a diversified portfolio of assets, which should guarantee that they have some of their investments in the best performing asset class at all times.”

As we wait to see whether or not the US economy can skirt a recession, we can expect market volatility to continue in the short-term. But, while we could yet see further daily market swings of 2% or more here in Australia, it’s important that investors maintain some historical perspective and focus on their long-term investment objectives rather than what’s happening in the market right now. “Remember,” says Stewart, “time is the friend of good investment decisions, and the enemy of bad ones.”

Rules for investing during volatile times

When markets are volatile, it's important to stick to some basic investment rules. Here are five tips to help you keep your investments on track.

1. Stick to your guns

Understand what you’re trying to achieve and how long you’re prepared to invest. The longer your investment timeframe, the more likely you’ll experience some form of short-term market volatility – make sure you’re comfortable with that prospect.

2. Understand how you feel about investment risk

Your investment strategy should reflect your attitude to investment risk – for example, investing in growth assets like shares can increase your long-term returns, but it’s likely you’ll experience greater short-term fluctuations than defensive assets like cash. Take a risk profile assessment to understand your tolerance to market volatility.

3. Invest in quality

Volatile markets aren’t the place for speculation, unless you’re prepared to lose your money on a bet that might or might not come good. Look for quality investments, and get a second opinion from your financial adviser.

4. Don’t try to time the market

Investing would be simple if you could always pick the best time to put your money in and take it out. Remember that time in the market, not timing the market, is the key.

5. Get advice from a qualified source

If you’re really serious about something – whether it’s on a sporting field, in business – you should seek advice. Building and managing your wealth is no different. If you don’t have a financial adviser, use our adviser referral service to find an adviser in your area.

Investor behaviour: that sinking feeling

17/04/2008

The share market shake-up of the past six months has had emotional, as well as financial, consequences. Fortunately, insights from the world of behavioural finance can help us deal with those emotions and improve our investment decisions.

Over the past five years the Australian share market has generated a total return of 129% (as measured by the S&P ASX 300 Accumulation Index to the end of March 2008). But, for the last six months of that period it lost approximately 17%.

In a perfectly rational world, we might look at those two numbers and comfort ourselves with the view that our long-term returns were more than acceptable.Yet much as we try to believe otherwise, the world of investment is not perfectly rational.

Research by Daniel Kahneman and Amos Tversky from the field of what’s referred to as ‘behavioural finance’ suggests that investors feel the pain of a loss much more deeply than the pleasure of an equal gain. This behaviour — known as loss aversion — can have a significant effect on how investors act. It is likely these effects are magnified by major market moves such as those experienced in the past six months in Australia and internationally.

Loss aversion is just one of a number of ‘hard-wired’ psychological biases that behavioural finance experts have identified in investors. Here’s a summary of the others.

• Money Illusion
  Identified by American economist Irving Fisher, the ‘Money Illusion’ leads investors to believe that monetary factors like prices, rates and currency values are fixed rather than variable. Many investors ignore the effect of inflation on the price of their assets. Others assume the interest rate they borrowed at will remain unchanged.
  
• Anchoring
  Anchoring refers to our tendency to see a recent price as the ‘right’ price. An investor who bought a speculative stock at the top of a boom, may have difficulty believing it was overpriced when they bought and prefer to believe the market is now ‘underpricing’ their stock.
• Regret and the disposition effect
  Regret is closely linked with loss aversion. Research suggests regret has such a strong emotional weight that investors are often reluctant to admit an error — such as buying a ‘poor’ stock. To avoid facing that regret, investors tend to defer selling stocks that have gone down and, as a result, they effectively ‘compound’ their mistake.
  
  This, in turn, leads to what University of Santa Clara academics, Hersh Shefrin and Meir Statman, called the ‘disposition effect’ — the tendency for investors to hold on to their ‘losing’ investments too long and sell their ‘winners’ too soon.
• Attribution and overconfidence
  Behavioural finance experts have also identified a tendency for investors to believe that good returns are the results of their investment skill and bad results the result of bad luck. This bias is known as self-attribution.
  
  Odean and Barber, business school professors at the University of California have pointed out that modern technology may have exacerbated this bias. Thanks to the internet, individual investors have access to vast amounts of information. Professor Odean has explained the consequences, “…when people are asked to make predictions based on information before them, the quality of those predictions doesn’t rise in line with increases in the amount of information they have. But the confidence people have in their predictions goes way up”.
• Mental accounting
  According to experts such as Richard Thaler, investors are prone to what he calls ‘mental accounting’ — focusing excessively on the gain or loss from each investment decision and not on their total portfolio or overall wealth.
  

Not logical, but reasonable

Experiencing these investment biases does not mean you are a bad or unintelligent investor. Indeed, as one of the leading lights of behavioural finance Meir Statman has said, “People in standard finance are rational. People in behavioural finance are normal.”

The key is to recognise that your reaction to investment events will be coloured by these biases and that these biases can damage your wealth:

• ‘Overconfidence’ can lead to excessive trading and excessive trading costs money. In research conducted by Odean and Barber the most active 20% of investors underperformed the least active 20% by 5.5% a year!

• By succumbing to the ‘disposition effect’, investors typically gave up 3.5% of their potential return.

• ‘Mental accounting’ means investors can be spooked out of investing by one poor performing stock, despite the fact that their overall position across their portfolio has improved.

Dealing with bias

As recent market events have highlighted, it’s difficult to manage these investment biases in the emotional environment of a falling market. It makes sense to tailor your investment strategies to beat the biases before they cost you money.

Staying unbiased

Investment experts have long promoted the benefits of diversification. One of its underestimated benefits is that a planned approach to diversification helps control some investor biases, particularly ‘overconfidence’.

If your investments are sensibly diversified you’re less likely to ‘fall in love’ with an investment and less likely to over-trade. Sensible diversification can also reduce the tendency towards ‘mental accounting’, as it encourages you to take a portfolio, rather than stock-specific, view.

There are also investment strategies that reduce the ‘disposition effect’. In 2005, BT and the University of Western Australia conducted research into 850,000 managed fund investors covering a 31 year period. It revealed that the combination of advisers and managed funds helps protect investors from the ‘disposition effect’.

Anecdotal evidence suggests that managed funds may ‘distance’ an investor from market sentiment in a way that direct shares do not. As a result, investors may be less prone to overreact to market moves if they invest in the market via a managed fund, rather than in direct equities.

There is also significant research to suggest that advisers add more discipline to individual investor decisions — especially when markets are moving. As one adviser told a BT research panel, “It’s our job to take the knives out of the kitchen”.

The buying game

For those with a steady nerve – or a long-term point of view – the decline in global markets may be less of a worry and more of an opportunity. Here’s a range of views on bargain hunting in the current market.

The bargain hunter’s view

Share prices both in Australia and overseas are now dramatically cheaper. The Australian share market is down 20% since November (as measured by the S&P ASX 300 Accumulation Index to the end of March 2008). And the global share market is down 13% over the same period (as measured by the MSCI).

When shopping for a car or a TV, a fall in prices makes the object look more appealing. However a fall in share prices tends to make investing less attractive. Why is that the case?

Understandably — but not logically — investors conflate the returns on money they’ve already invested with the risk and return potential for money they have to invest now. Yet the two are clearly distinct. Any loss (or gain) made on previous investments has absolutely no effect on any ‘new’ money you may be looking to invest.

What you need to consider is the potential return on your new investment. Could it be affected by the same economic and market conditions that caused recent market falls? If so, does it make sense to be cautious? Perhaps, but those factors are now priced into investment markets. You get to buy shares at lower prices because the market is already taking those risks into account.

It’s also important to remember that the conditions that forced markets down (eg the ‘credit crunch’ of the past six months) may be losing their impact, or overtaken by other factors such as the large interest rate cuts we have seen in the US.

As the article on page 10 points out, it is tremendously difficult to separate emotion from investment decisions. Yet taking the opportunity presented by lower prices can make it easier to achieve the investment returns you need to improve your lifestyle.

The stock-picker’s view:

Crispin Murray, Head of Equity Strategies, BT Investment Management

In the past six months the Australian share market has snatched back a large chunk of its previous gains, gains that in many cases were driven by ‘cheap’ money and a booming global economy. Now those factors have turned, a credit crunch is biting and there’s increasing evidence that the US economy is weakening.

Many companies that prospered in early to mid-2007 — companies with business models based on rapid expansion fuelled by cheap money — are being hammered as that model unwinds. BT funds paid a ‘performance price’ in 2007 for not investing in those companies. But that has helped insulate our funds now that the ‘tide has turned’.

We are now at a very interesting point. The recent profit reporting season showed no evidence of a significant deterioration in companies’ operating environment. However there are negatives out there, tightening monetary policy and slower growth being the most obvious, while a rising dollar makes life hard for Australian exporters.

We are at a point in the market cycle where significant value is emerging, but where short term earnings uncertainty is extreme.

So, a long term view is vital. You have to be aware of the risks, but you need to understand what you are being paid to take such risks. With the market expecting the worst, you can be well compensated for risk and that’s why we are selectively buying into companies that have been over-sold.

There are opportunities across different sectors, but our preferred targets are companies with good market positions, strong balance sheets and proven management. We continue to place a premium on liquidity so companies like QBE, Rio Tinto, Qantas and Origin Energy have been high on our list of attractive buys.

The super investor’s view

Thanks to some significant new tax concessions, vast sums of money were poured into superannuation in 2007. Those tax changes effectively made income from super tax-free after the age of 60 and confirmed super’s position as a premier long-term investment.

Recent market falls have obviously dragged down the value of those super investments. According to SuperRatings, the 2007/2008 financial year could be the first negative return for balanced super funds since 2001/02.

So how should super investors react? As we have discussed above, in the midst of market turmoil there is a temptation to avoid investing your super in shares. Yet super is explicitly designed for the long-term and as our article on page 8 shows, over the long term, share market returns more than make up for the occasional negative year. If you’re investing for a retirement that is years away, investing in shares offers the potential of more attractive returns than most other asset classes.

Indeed a combination of improved tax concessions and lower asset prices may now make share-based super funds a classic buying opportunity.

The economist’s view:

Dr Chris Caton, Chief Economist, BT Financial Group

The negatives in the current economic environment are now so well known there is no point enumerating them again. The most important factor is the US recession. However I can confidently assert that the US will come out of the recession it is now going into. There are three factors driving this forecast:

• This US housing collapse (which helped start this whole downturn) cannot keep getting worse.
• The fall in the US dollar has been so steep it’s now adding real legs to America’s export performance and that’s good for US growth.
• The Fed is on the job, injecting serious liquidity into financial markets and cutting rates dramatically.

What does this mean for investors? The big issue is the length and depth of the recession. If it’s a mild one, it may already be priced into markets and we may be nearing the bottom. Picking turning points in an economic cycle is notoriously hard. Yet, investors who have ridden the market down should assess whether bailing out now means avoiding only the last leg of the road down, but missing the traditionally large early surge when a recovery arrives.

It is valuations that should give investors most comfort, especially if they have cash on hand. Research I’ve been looking at suggests that in Australia, price to earnings measures are saying that the last time shares were this ‘cheap’ was in 1990. P/E ratios on global markets are now the lowest they’ve been since 1990.