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Value investing skills #3: Behavioural edge

There are arguably four broad categories where it is possible for investors to enjoy some sort of advantage over their peers. Here we consider the behavioural ‘edge’ and how value investors can benefit from one

22/02/2018

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

So far, in Value investing skills #1 and Value investing skills #2, we have highlighted the informational and analytical ‘edges’ to be had through a value approach to investing. Having done all the hard work identifying the investment pool you want to fish in and assessing the quality of what you find there, you next have to make a decision on whether to buy.  This is where value investors can enjoy a behavioural edge.

#3 - Behavioural edge

You can be the best company analyst in the world but it is the specific investment decisions you make that determine whether or not you outperform the market and your peers.

Did you buy or did you sell a stock? At what point? How much of it did you choose to trade? And, most important of all, how consistent were your decisions this time compared with every other time you have bought or sold a business?

Leave emotions at the door

Say you had decided you wanted to buy into a company yesterday but do not like the look of it so much today, then you have more than likely allowed emotion to encroach on your investment process – and emotion is the enemy of an edge.

To have an edge in this part of your process, you need to have a consistent decision-making framework – and that means acknowledging the human behavioural aspect of investment.

It is totally understandable why emotion can creep into any investment process. The decision of whether or not to buy into a company is an extraordinarily difficult one.

You are looking to evaluate all sorts of things about the business – its valuation, its financial strength, the quality of its management, competitors, suppliers and so on – and trying to distil all that into a simple yes/no answer. All in your head. Your human head. 

Beware the human brain

The trouble is, the way the human brain has evolved over so many thousands of years means that, when we are faced with a difficult question, it will perform a little sleight of hand.

Behavioural psychologists such as Daniel Kahneman have shown our brain will switch the question from ‘Should I invest in this company?’ to ‘Do I like this company?’ – and it does this so subtly you do not even notice.

Unless of course you understand in advance that is the sort of trick your brain can pull and so take steps to make the question simpler and thus your investment process more consistent. When we are looking at companies here on The Value Perspective, for example, we split the question into two:

  1. What are the associated risks of buying into a business?
  2. What are the potential rewards?

This has the effect of turning that initial, key question – ‘Should I invest in this company?’ – into a much easier decision to make and one that can be made in a much more consistent way.

It is this sort of consistent process and reducing the potential failures of human behaviour that, we would argue, could give you an investment edge over others. 

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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