NN Investment Partners

Balancing Behaviour

13 Février 2017 Par Valentijn van Nieuwenhuijzen
 (Photo: NN Investment Partners)

The battle continues. The battle between good economic news and rising political uncertainty. Markets need to keep a close eye on the balance between these two forces to judge how upside and downside risks are evolving. On top of that market behaviour itself could easily generate feedback loops to the economic or political reality on the ground,

which complicates matter even further for investors who are contemplating how to position the portfolios they manage. And those individual investors are obviously part of the crowd that make up the overall market, which makes their thinking and behaviour a part of the constantly adapting economic ecology that they aim to analyse. This is why the battle for investors is actually not only about understanding economic fundamentals and politics, but just as much about assessing how other investors behave. How investor sentiment influences their positioning and flows.

 Especially when economics and politics point in different directions, as is the case currently, it is crucially important to understand the behavioural forces that might be the swing factor for market direction. To make a psychological profile of the market is obviously not easy either, but if done well it provides an important part of the puzzle that explains why markets deviate so often from the “efficient” pricing model. And even if market behaviour is better understood it is not always straightforward how to exploit it as an investor. For example, herd behaviour and the contagion of rumours can help to explain why market emotion can drive prices away from efficient pricing on the underlying economic reality (and the future risks attached to it). Even when you correctly spot these emotions, however, it might still not be obvious what to do as the options to join the crowd or to use signs of excessive behaviour as a contrarian indicator (and take an opposite position) will both be on the table.

 Next to identifying this type of behaviour it therefore also has to be diagnosed, researched and interpreted in terms of the most likely market impact that it will generate going forward. Moreover, multiple types of emotions and behaviour will create cross-currents that will jointly create the new market reality. The behavioural profile that we compose of Mr Market is therefore a well-researched overview that captures drivers of sentiment, expressions of herd behaviour and maps investor positioning and flow dynamics. For all the factors that we utilize to design the profile, we have first analysed in which stage we should “follow” their most recent impulse or when we need to “go the other way” once overshooting territory is reached.

 Sometimes rising sentiment or investor flow momentum can be attractive to follow as optimism builds in the market and the outperformance of asset classes that have benefitted from previous flows can trigger additional allocations by fund managers into the same asset classes. At the same time both optimism and pessimism as well as investor positioning can get over-extended after period of one-directional moves in the market.

 It can also be profitable to jump on the bandwagon on an investment theme that is still building as some of these themes can last for a substantial period of time. The multi-decade bond market rally is probably one of the most persistent themes ever seen, but more recently also the “search for yield” and “low vol equity” themes have lasted remarkably long periods.

 A traditional (but effective) way to exploit trends is to simply look at prices or returns themselves, through graphs or more rule-based signals based on market prices. Often gradual and slow moving price trends create the opportunity to exploit the momentum factor a bit further, while a sharp and/or non-linear acceleration in prices hints of overshooting and the need for caution or contrarian thinking. Complementary to market pricing it can also be informative to analyse the evolution of investor sentiment.

 Eventually all these behavioural factors need to be combined in an evidence based and consistent way. This means assessing the information value of the different factors have and to understand what added value they have to one another. Only once this is done in a balanced way can a useful behavioural profile be designed. A behavioural analysis that substantially enhances the investment decision making compared to a situation where only economics and politics are taken into account.

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