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Contents Elephants In Finance .................................................................................................................... 5

Price vs Value ................................................................................................................................ 6

Buying Into Booming Businesses .............................................................................................. 7

Fads in Fitness and Finance........................................................................................................ 8

Patience is a Virtue ....................................................................................................................... 9

Technical Analysis ...................................................................................................................... 11

There’s Always Something To Worry About .......................................................................... 13

The Outcome Bias ..................................................................................................................... 14

The Hedgehog and the Fox ...................................................................................................... 15

Amateurs vs Professionals ....................................................................................................... 16

Irrationality ................................................................................................................................... 17

Margin Lending ........................................................................................................................... 18

Monetary Mysteries ................................................................................................................... 20

Emergent Phenomena ............................................................................................................... 21

Smart vs Dumb Money ............................................................................................................. 22

The Dunning-Krueger Effect ..................................................................................................... 23

Same Same, But Different ........................................................................................................ 24

The Overconfidence Bias .......................................................................................................... 26

Career Risk .................................................................................................................................. 27

Investing For The Long Run...................................................................................................... 28

Art vs Science ............................................................................................................................. 29

The Rashomon Effect ................................................................................................................ 30

Herding......................................................................................................................................... 31

Sequencing Risk ......................................................................................................................... 32

Diversification ............................................................................................................................. 34

The First Bubble ......................................................................................................................... 35

Short Selling ................................................................................................................................ 36

Skepticism ................................................................................................................................... 38

Timing The Market ..................................................................................................................... 39

Patience ....................................................................................................................................... 40

Recency Bias ............................................................................................................................... 41

Probability vs Possibility ............................................................................................................ 42

Survivorship Bias ........................................................................................................................ 44

Risk vs Uncertainty .................................................................................................................... 45

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Animals in Finance ..................................................................................................................... 46

Commodities ............................................................................................................................... 48

The Australian Sharemarket...................................................................................................... 50

Silly Stimulus ............................................................................................................................... 52

Subjective Value ......................................................................................................................... 53

Rear View Mirror Investing ....................................................................................................... 54

Opportunity Cost ........................................................................................................................ 55

The Importance of Free Trade .................................................................................................. 56

Ceteris Paribus ............................................................................................................................ 57

Loss Aversion ............................................................................................................................. 58

Prospect Theory ......................................................................................................................... 59

Hindsight Bias ............................................................................................................................. 60

Action Bias................................................................................................................................... 61

There’s Nothing Riskier Than Cash ......................................................................................... 62

The Complexity Bias .................................................................................................................. 63

Compound Interest .................................................................................................................... 65

The Maths of Gains and Losses .............................................................................................. 66

Value and the Greater Fool Theory .......................................................................................... 67

The Behaviour Gap ..................................................................................................................... 69

The GFC ....................................................................................................................................... 70

Contrarian Investing ................................................................................................................... 71

The Risk Premium ...................................................................................................................... 73

The Wealth Effect ...................................................................................................................... 75

Passive vs Active Investing ...................................................................................................... 76

Moral Hazards ............................................................................................................................. 78

Bond Yields ................................................................................................................................. 79

The Time Value of Money ......................................................................................................... 80

The Carry Trade .......................................................................................................................... 81

The Laffer Curve ......................................................................................................................... 82

Protectionism .............................................................................................................................. 83

Job Creation Programs .............................................................................................................. 84

Trade Wars .................................................................................................................................. 85

Inflation ........................................................................................................................................ 86

Making Money Out of Thin Air ................................................................................................. 87

P/E Ratios .................................................................................................................................... 88

Tackling Automation .................................................................................................................. 89

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Home is Where the Heartbreak is ........................................................................................... 90

How Regulations Can Stifle Business ..................................................................................... 91

Negative Gearing ........................................................................................................................ 92

Monetary Policy .......................................................................................................................... 93

The Yield Curve ........................................................................................................................... 94

Knowing What You Control ...................................................................................................... 96

Economic Fairy Tales ................................................................................................................. 97

Quantitative Easing .................................................................................................................... 98

Lying With Statistics .................................................................................................................. 99

The Disposition Effect ............................................................................................................. 101

Disclaimer

Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances.

This report is current when written. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not

appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.

When considering a financial product please consider the Product Disclosure Statement. Stanford Brown is a Corporate Authorised

Representative of The Lunar Group Pty Limited. The Lunar Group and its representatives receive fees and brokerage from the provision of

financial advice or placement of financial products. The Lunar Group Pty Limited ABN 27 159 030 869 AFSL No. 470948 © 2018 Stanford

Brown.

5

Elephants In Finance There is a famous Indian parable that is taught in philosophy classes

throughout the world to prevent absolutism and foster tolerance for the views

of others. To paraphrase, six blind men are taken to “see” an elephant for the

first time. One man feels the elephant’s tusk and declares that the elephant is

like a spear, one man feels the elephant’s legs and declares that elephants

are like trees, another man feels the trunk and declares the elephant is like a

snake. Each man has a wildly different view of what constitutes an elephant

depending on what part of the elephant they happen to come across.

The parable ends as follows:

“And so these men of Indostan

Disputed loud and long,

Each in his own opinion

Exceeding stiff and strong,

Though each was partly in the right,

And all were in the wrong!”

There are few domains with as much noise and chatter as investing. Every

day you’ll hear some expert’s opinion on the trade war, yield curve inversion,

or whatever the flavour of the month is. Much like the six blind men in the

parable, these opinions often have a grain of truth, but they are incomplete

because the pundits tend to have major blind spots (pun intended) in their

understanding of the world.

So the next time you read that so-and-so is predicting a recession or making a

stock pick, remember that they probably haven’t seen the whole elephant!

6

Price vs Value If you had the choice of investing in a 3-bedroom house in Woollahra or an

identical house in Wentworthville, which would you choose? Many would

automatically choose the more prestigious Woollahra, without asking the

most important question in investing – what price am I paying? A bargain in

Wentworthville will almost always be more profitable than a splurge in

Woollahra.

The same is true for investing in shares. The price you pay is often more

important than what you’re buying. Although Google has become so ubiquitous

that it is a verb, an investment in the US listing of Domino’s would have

comfortably outperformed Google’s parent company Alphabet since the two

companies IPO’d in 2004. When it comes to investing, what you pay is often

more important than what you’re buying.

Source: Bespoke Investment Group

In the words of legendary distressed debt investor Howards Marks “No asset

is so good that it can’t become a bad investment if bought at too high a price.

And there are few assets so bad that they can’t be a good investment when

bought cheap enough.”

7

Buying Into Booming Businesses Every decade there are innovations that radically change the way we live our

lives. From combustion engines to computers, these innovations spawn

some of the largest companies in the world, meaning that there’s money to

be made for investors. Optimism about the growth of these industries is the

fuel for most investment bubbles. In the late 1990’s there was speculative

fever about the potential of the internet, in the 1980’s there was speculative

fever about the potential of the Japanese economy, in the 1920’s there was

speculative fever about the potential of electrical utilities and the radio, in the

1840’s there was speculative fever about the potential of railway, in the

1720’s there was speculative fever about the potential of transoceanic trade.

In each of these cases, investors correctly identified industries with strong

growth prospects, yet the vast majority of them lost a bunch of money –

why?

Imagine if you had a friend who wanted to open a Vietnamese restaurant in

Cabramatta and asked you to invest in it. You’d probably ask a few questions

before pulling out your chequebook, the most pertinent being why your friend

thinks the restaurant would make money. There are lots of Vietnamese

people in Cabramatta, so there is ample demand for the product. But there

are also dozens of Vietnamese restaurants in Cabramatta, so there needs to

be a compelling reason to think those customers will choose your restaurant

over the others. It’s not enough to be in a growth industry, you also need to

be a top performer.

But what if nobody had ever thought of opening up a Vietnamese restaurant

in Cabramatta? Imagine the growth prospects – there would be customers

lining up for hours for a taste of home! You’d probably jump at the chance to

invest. The issue is that your friend would probably be offering equity to other

investors, meaning you’d have to engage in a bidding war in order to get your

slice of the pie. If the business makes $500,000 a year, what’s a fair price to

pay? A million dollars? 20 million dollars? It doesn’t matter how good the

growth prospects are, if you get too enthusiastic and pay a billion dollars for

the only Vietnamese restaurant in Cabramatta you will most likely lose

money.

There are plenty of industries to get excited about today, from solar energy to

biotechnology to cultured meat. We will have opportunities to invest in these

industries, and there will be the potential to make eye-popping returns.

Before parting with your money, you should ask:

• Why will this particular company do well? Are you investing in

Facebook or MySpace?

• Are you paying a fair price? What you pay is more important than what

you buy – even the best assets can become too expensive

8

Fads in Fitness and Finance In many ways, seeking financial advice is like getting advice on health and

diet. In both fields, consumers are often unable to make informed decisions

due to a lack of education, meaning they often copy what everyone else is

doing and perpetuate fads.

Much like fad diets (juice detoxes, alkaline diet, etc), there are fad

investments (cryptocurrencies, technology stocks, etc). Fads will only

become more popular as the rise of the internet grants a platform for anyone

with an internet connection, irrespective of their qualifications, to share advice

on everything from investing to intermittent fasting (sometimes both!).

Consumers who fall prey to these fads in fitness and finance often share a

common flaw: they’re looking for an easy way to achieve something difficult.

There is little difference between a get rich quick scheme and a workout

routine that will give you killer abs in one month. Both are promising

wonderful results with minimal effort, both often involve paying a fraudster a

fee, and both rarely pan out.

When it comes to fitness and finance, the simplest strategies are often the

best ones. You will achieve most of your health goals with a balanced diet

and regular exercise. Likewise, you will achieve most of your financial goals

with a well-balanced diversified portfolio and sensible spending habits. Most

people don’t follow these strategies because they require discipline and

patience. The value of a quality adviser is to work with you to set goals and to

keep you on track.

9

Patience is a Virtue One of the joys of checking the junk folder of your emails is seeing how

people online are trying to scam you. These scammers typically sell things

that are highly desireable but require hard work and patience. Want to lose

weight? Forget going to the gym and adjusting your diet - buy this miracle diet

pill! Want to become rich? You can work hard and be sensible with your

money, or you make millions by taking up this once in a lifetime opportunity!

These guys are even selling love!

Fitness, love and wealth all require effort and patience to build and maintain,

which is why they are out of reach for many people. The scammers hope that

their victim’s desire to achieve difficult things quickly with minimal effort will

outweigh their common sense – unfortunately, they are often correct.

In theory, it should be easier to achieve investment success than keep fit or

stay in love. Fitness and love tend to require ongoing effort. You can be fit

today, but if you stop exercising or have a diet blowout you’ll soon be unfit.

You can be in a great relationship today, but if you take it for granted and

neglect your partner the relationship will quickly deteriorate.

10

Successful investing, on the other hand, mostly involves sitting on your

hands. If you’re invested in a decent strategy, the best course of action in

most cases is to do nothing – which is often incredibly difficult. There is an

endless supply of gibberish masquerading as intelligent conversation on

investments, and investors are often tempted to tinker with their portfolios to

try and get ahead. The value of a financial adviser isn’t just formulating a good

strategy, but helping their clients with one of the hardest tasks of investing –

doing nothing!

11

Technical Analysis Whilst perusing the interwebs earlier this week we came across this doozy of

a headline from CNBC, which is supposedly “The world leader in business

news and real-time financial market coverage”.

We were expecting gibberish, and boy did we get gibberish!

The kind of analysis above (if you could call it analysis) is known as Technical

Analysis, which is an attempt to predict the price of an asset by studying its

past price movements. This has been compared to forecasting tomorrow’s

weather by studying yesterday’s weather. Technical analysts believe that

prices follow patterns, and if you can correctly identify the pattern (the one

above is known as a rising wedge) before it plays out, you can make

handsome returns.

There’s no intelligent reason to believe that prices follow predetermined

patterns based on their previous movements, so why does Technical Analysis

still get press time?

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It helps that Technical Analysis is full of fancy names. Fibonacci ratios,

stochastic oscillators, triple exponential moving averages – you may have no

idea what any of this means but gee-wiz does it sound impressive! These

impressive terms are then thrown at unwitting investors, who are “let in” on

the big secrets to making easy money using Technical Analysis and

encouraged to open a brokerage account to give it a go!

The vast majority of investors subsequently lose a bunch of money trading

obscure assets such as binary options on foreign exchange rates, as there is

no intelligent reason to think that Technical Analysis works. They

subsequently close their trading account and the unscrupulous broker moves

on to their next victim.

Whenever investors are offered to learn more about exotic investment

strategies like these, they should keep in mind that if someone had actually

developed a strategy to beat the market consistently, they wouldn’t be

sharing it for free on the internet!

13

There’s Always Something To Worry

About Yield curve inversions, trade wars, recession forecasts – there have been

plenty of scary developments in recent weeks to be worried about. During

times like these, investors should remember that there will always be

something to worry about. In fact, you wouldn’t make any money off shares if

there wasn’t something to worry about!

Let’s take a couple of trips down memory lane. Our first stop is January 2007,

just before the GFC. Shares have been soaring for three years, with many

investors borrowing money to get in on the action. All the major economic

bodies are predicting above-average global growth, let alone a recession.

Sentiment is rosy, meaning that if you want to invest you’ll have to overpay to

convince someone to sell their shares.

Our second stop is January of 2009, just before shares are going to kick off .

Most global sharemarkets have fallen 50% in the wake of the GFC, the global

economy is in deep recession, and there are calls that the worst is yet to

come and we will have another great depression. Investor sentiment is at its

lowest levels since the 30’s, meaning that other investors are scrambling to

find people to take their shares off their hands, settling for just about any

price.

Which of the two scenarios above were more dangerous for investors? When

sentiment was high and investors were predicting blue skies forever? Or

when sentiment was low and investors were worried about the end of

capitalism? If you were buying a house, would you rather be in a bidding war

with other buyers or would you rather be the only one at the auction? The

swings from fear to greed will always be present in financial markets,

meaning that investors would do well to abide by Warren Buffett’s maxim –

“Be greedy when others are fearful and fearful when others are greedy”.

14

The Outcome Bias

Imagine two financial thrill seekers that take their life savings to the casino.

They end up at the roulette table, with one betting the house (literally) on black

and the other favouring red. One will walk out having doubled their money

whilst the other won’t have enough to pay for their bus fare to Centrelink.

Although the subjects of our example made equally foolish decisions, we tend

to view the unlucky gambler more harshly than the lucky gambler. This is a

result of the outcome bias, where we judge the quality of a decision by its end

result rather than by the process used to arrive at the decision. The bias is

particularly dangerous for investors, as luck and randomness play an

uncomfortably large role in investment performance (e.g. was your average

Sydney home buyer in 2010 smart or just lucky?).

When selecting money managers, many investors use recent performance as

a proxy for the quality of the product. The issue with this is that a portfolio of

stocks chosen by a toddler can outperform a portfolio chosen by Warren Buffett

for weeks, months, or even years. In the long run, however, good luck tends

to run out, so investors should place higher significance on the strategy and

decision making process of a manager than their short-term relative

performance.

As our Chief Investment Officer Ashley Owen said in a recent seminar, our goal

at Stanford Brown is to help you avoid this guy!

15

The Hedgehog and the Fox One of the most famous works of philosophy is Isaiah Berlin’s The Hedgehog

and the Fox. A hedgehog only knows one trick (see below). Foxes, on the

other hand, have many tricks up their sleeve, hence the phrase “as cunning as a fox”. Ask anyone you know with a chicken coop about the vigilance

required to stay one step ahead of a fox!

The Hedgehog and Fox analogy can be extended to contrast those with only

one way of seeing the world vs those with multiple perspectives. There are

many faiths of investing, with millions of devout followers. Some are value

investors and pray to Warren Buffett at night. Others are index investors,

worshipping their patron saint Jack Bogle. These are investing hedgehogs

with only one way of viewing investment markets. A common giveaway of an

investing hedgehog is the phrase “it makes no sense that the market…”.

What they’re essentially saying is “Prices are not moving the way I thought

they would, so there must be something wrong with other investors”. The

issue is that markets are incredibly complex and in constant flux, meaning

that a singular viewpoint is often incomplete and/or outdated.

So how do you become a Fox in investing or other domains in life? Following

the mantra “strong opinions, weakly held” is a good start. There’s nothing

wrong with having a strong view on investing, politics, or any other subject.

Where people get in trouble is when they stick to their guns despite ample

evidence that they’re mistaken. This is more likely to occur to people who

think highly of themselves and their abilities.

Charlie Munger (an esteemed minister of the church of value investing)

attributed his success to having a low opinion of his abilities “If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and

think it's 120“.

16

Amateurs vs Professionals In 1970 the famed American engineer Simon Ramo released the book

“Extraordinary Tennis For The Ordinary Player”, where he posited that Tennis

is in fact two games – one played by professionals and one played by

amateurs. When professionals play tennis, the match is won by beating your

opponent (e.g. accurate serves, superior strategy). When amateurs play

tennis, the match is won by not beating yourself through novice errors (e.g.

double faults, hitting the net). Based on Ramo’s studies, 80% of points in

professional tennis are won, whereas 80% of points in amateur tennis are

lost.

The key insight from Ramo’s research is that most people would be better off

trying to avoid making major mistakes than trying to be brilliant. When it

comes to tennis, that involves playing conservatively and “giving the other

fellow as many opportunities as possible to make mistakes”. When it comes

to investing, that may involve choosing a low cost index fund that matches

the market return rather than trying to select a portfolio of stocks to beat the

market. If someone wants to get rich, avoiding major mistakes such as

borrowing too much, saving too little and getting divorced is much easier than

trying to be an investing genius.

In the words of Charlie Munger, investing legend and right hand man to

Warren Buffett “It is remarkable how much long-term advantage people like

us have gotten by trying to be consistently not stupid, instead of trying to be

very intelligent”.

17

Irrationality In last week’s TW3, we offered our readers a bottle of wine if they correctly

predicted the winning portrait in the Archibald Prize. There is a subtle, but

important, difference between asking which portrait you thought was best

and asking which portrait you thought would win. Choosing your favourite

portrait is simple, predicting the behaviour of others can be quite difficult.

In essence, when we invest we are betting that in some point in the future

other investors will like our investment more than they do today, and will be

happy to pay a higher price for it. In other words, we are making a prediction

about the future behaviour of others. The economist John Maynard Keynes

called this second degree decision making – successful investing isn’t finding

the best asset, but rather finding what the market will think is the best asset.

This is arguably the most difficult aspect of investing – how can we predict

the behaviour of others when there is ample evidence that they act

irrationally? Why would a doctor still smoke cigarettes despite knowing the

risks of smoking? Why would someone feel uneasy boarding a plane but feel

fine getting into a car, despite the risks of being in a car crash being

significantly higher? Why would someone buy a lottery ticket despite being

five times more likely to be struck by lightning?

The correct answer is that there is no way to reliably predict the behaviour of

others, any investment manager who tells you they can is full of it!

18

Margin Lending During the latter stages of the market cycle, investors often get a call from

their stockbroker that goes something like this - “I know you’re fully invested

in the market, but it’s a shame that you can’t make even more money! You

know what? How about I lend you some money so you can supercharge your

returns!”. And why wouldn’t the investor say yes? The market has been

humming along nicely, investor sentiment is rosy, they may as well earn a

few extra dollars!

Imagine our investor has $100,000 of cash to invest, plus the option of taking

out a 50% margin loan that would double their purchasing power.

If shares continue to rise, everyone wins! The investor almost doubles the

return they would have otherwise received, and the ever-benevolent

stockbroker gets an interest payment for their troubles!

19

But what if the unthinkable happens and shares don’t rise? Now the investor

has doubled the loss they would have otherwise suffered, and still needs to

pay our dear friend the stockbroker. To make matters worse, the stockbroker

is now worried that the investor may not be able to pay off their loan, and will

request more money to be put up as collateral, or else they will sell the

shares at a steep loss in order to recoup the loan (known as a margin call).

When it comes to investing in any asset, there are few things more ruinous

than being a forced seller. One of the most important skills for an investor to

have is the ability to hold steady when markets have their inevitable

downturns. The risk of a margin loan isn’t just that it magnifies any losses, but

that you could become a forced seller at the worst possible time.

Investing in stocks is risky enough, there is no need to magnify that risk with

a margin loan in the pursuit of quick returns. If you know someone who is

thinking of taking out a margin loan, share with them the following advice

from the great American economist Paul Samuelson ”Investing should be

more like watching paint dry or watching grass grow. If you want excitement,

take $800 and go to Las Vegas.”

20

Monetary Mysteries Nic was recently in Japan for the Rugby World Cup, fulfilling a longtime

dream of being disappointed by the Wallabies overseas. When travelling over

300km/h on the Shinkansen between cities, Nic passed time reading stories

of the famed detective Hercule Poirot.

For those not familiar with Poirot, the stories tend to follow a simple

structure:

• Poirot and his assistant Captain Hastings are asked to solve a mystery

(usually murder or robbery)

• After a review of the evidence, Hastings is either clueless or makes a

quick conclusion based on misguided assumptions. Poirot, on the other

hand, weighs up the evidence and thinks long and hard

• Inevitably, Poirot solves the mystery, leaving Hastings embarrassed

that he didn’t think of the solution despite having the same evidence

Whether it’s Poirot, Sherlock Holmes, or Auguste Dupin, the best detectives

don’t solve mysteries because they have information others don’t. Rather,

they have superior methods of interpreting the same evidence everyone else

has. After reading a few of these stories, the reader quickly learns that their

first impressions are almost always wrong, and if they want to solve the

mystery they’ll need to do some thinking.

A savvy investor has many similar traits to these great detectives. Investing

boils down to making predictions about the future movement of the price of

an asset. How do we make these predictions? We gather evidence and

(hopefully) think long and hard. Investors get in trouble when they come

across shoddy evidence (a hysterical newspaper headline, a friend’s foolproof

idea, etc) and think that they’ve solved the monetary mystery. Almost always,

they will be wrong.

One of the greatest benefits of a quality financial adviser is relieving their

clients of the need to try and solve these monetary mysteries. At Stanford

Brown we spend all week (and many weekends) gathering evidence and

thinking long and hard so that our clients don’t have to. The fact that our

Managed Accounts have been named Australia’s best for two years running

suggests we’re doing a good job thus far!

21

Emergent Phenomena One of nature’s great sights is to watch a murmuration of starlings. Despite

not having a centralised decision maker, the starlings move in unison in

response to potential threats. The behaviour of a murmuration of starlings is

an example of emergence, whereby the simple interactions between

individual actors combine to create a complex system.

The behaviour of systems with emergent phenomena are impossible to

predict with precision, as the system is more complex than the sum of its

individual parts. Scientists can’t predict the movements of starlet

murmurations even though they know everything about starlets. Likewise,

one could know everything there is to know about the companies within a

stock market and still not be able to make reliable short-term predictions

about the direction of the market.

Trying to beat the market is so difficult because price movements are the

cumulative result of hundreds of millions of trades made by investors. Whilst

there are observable, repeatable laws in the natural sciences, there are no

laws governing the cumulative behaviour of millions of investors. Isaac

Newtown, arguably the greatest scientist of all time, once remarked after

losing a fortune in a speculative bubble “I can calculate the movement of the

stars, but not the madness of men”.

22

Smart vs Dumb Money Whether it’s building a fence or dealing with pests, if you aren’t sure what to

do, it’s often a good idea to consult a professional. Many investors believe the

same applies with their money management. Surely someone who has

undergone years of higher education and deals with markets every day will

have a better idea than your run of the mill investor?

The media perpetuates this notion by labelling professional investors “smart

money”, whilst considering individual investors like you and I “dumb money”.

This is because they want you to believe that you can make more money by

reading articles like the ones below.

There are two reasons why this is a flawed exercise. The first reason is that

by the time a good idea makes it to the pages of the financial media, it’s

probably no longer a good idea because you’ll be arriving late to the party and

likely overpaying for the asset. The other reason is that smart money is often

not very smart. One American fund manager quipped that “When you use the word ‘professional’ on Wall Street, it doesn’t mean they know anything. All it

means is that they do it for money”. The definition of a professional in The

Devil’s Financial Dictionary is “someone who acts like an amateur with other

people’s money”.

So if you engage a professional to help with your finances, how do you know

whether you’re dealing with “smart” money? A good starting point is their

demeanour. Do they seem to have an inflated opinion of their abilities? Are

they making promises that seem too good to be true? Are they trying to

impress you with random jargon? If the answer to these questions is yes,

you’re likely paying “smart” fees for “dumb” returns

23

The Dunning-Krueger Effect In An Essay on Criticism, the famed English poet Alexander Pope wrote:

“A little learning is a dangerous thing;

Drink deep, or taste not the Pierian spring:

There shallow draughts intoxicate the brain,

And drinking largely sobers us again.”

The Pierian spring Pope refers to represents knowledge of the arts and

sciences, with the intention of warning readers of the dangers of

overestimating your abilities in a domain you don’t have much experience in.

A few centuries later, two American psychologists formalised Pope’s

observations with a theory that is known as the Dunning-Kruger effect, which

is best summarised by the chart below.

The American investor Henry Kaufman once said that there are two people

who lose a lot of money: those who know nothing, and those who know

everything. When it comes to investing (especially property investing), having

a degree of certainty is usually a red flag that you are underestimating the risk

of your investment. If you or someone who manages your money feels

certain about an investment, keep in mind a quote from Voltaire “Doubt is not

a pleasant condition , but certainty is absurd”.

24

Same Same, But Different If you have visited Thailand you probably would have come across the phrase

“same same, but different”, perhaps on a sign similar to the one below, more

likely on a fluorescent singlet worn by a sunburnt backpacker. You’ll most

likely hear the phrase when that sunburnt backpacker goes to the markets

and asks whether the Rolex they’re buying for $10 is genuine – “same same,

but different”.

Nic couldn’t help but think of the phrase when reading the following passage

in latest instalment of Stanford Brown’s Monthly Top 5:

“whether it is tulips or telephones, railways or radios, canals or cars, South Sea riches or smart-phones. Each boom captures the public imagination and

leads to over-investment, over-speculation, and over-gearing, but each boom

ends in tears and losses. For every winner there are dozens or hundreds of

losers. That goes for companies and for speculators”.

As an investor, you will never be able to keep up with all the technological

and economic innovations being made every day. Learning all there is to

know about the rise of software or the causes of the Global Financial Crisis

isn’t necessarily going to help you make money, because the threats and

opportunities facing an investor today are different to the investor of

yesterday - the next Bill Gates won’t make software, and the next market

meltdown won’t come from sub-prime lending in the US housing market.

One thing that won’t change anytime soon, however, is human nature. Every

market cycle is different, but the swinging pendulum of investor sentiment

from exuberance to despair will always remain. Investors get in trouble when

they forget that the worst time to invest is usually when everyone else is

exuberant, and that the best time to invest is usually when everyone else has

concluded that the end is nigh.

25

If you ever hear someone say “this time it’s different” remember what

they’re really saying is “look, I know every single time in human history people have gotten this excited about an investment it has ended up horribly,

but I think it will work out this time!”.

26

The Overconfidence Bias In a podcast interview, chess master, best-selling author, and quant investing

guru Adam Robinson shared a story of an old scientific study that has a

profound lesson for us all but particularly for investors. A psychologist tested

how accurately professional handicappers could predict horse races with

varying levels of information. In the first round of testing, the handicappers

could choose five pieces of information to help them predict the winner

(these would vary from person to person). In the second round, the

handicappers were given ten pieces of information, and in the third and fourth

rounds they were allowed 30 and 40 pieces of information respectively.

Curiously, access to additional information had no impact on the accuracy of

predictions. However, as the handicappers were given more information, their

confidence in their predictions increased. Handicappers with 40 pieces of

information were more than twice as confident in their predictions as they

were when they were given five pieces of information, even though their

predictions were no more accurate.

This bias is known as the overconfidence effect, and it is one investors need

to watch for. Overconfidence breeds complacency, and results in investors

overestimating their chances of success whilst underestimating the risk. It is

intuitive to think that acquiring more information would improve investment

outcomes, but often it results in overconfident investors who are blinded to

information that contradicts their beliefs.

27

Career Risk As we wrote in a recent Finance 101, many retail investors have an elevated

opinion of the abilities of investment professionals, typically because

investment professionals tend to have an elevated opinion of their abilities

and market their products accordingly. It is all too common to see an investor

pay above-average fees for average performance, so how can you avoid

making the same mistake? It helps to understand the most money managers

are incentivised to be average.

As it turns out, if you do the same thing as everyone else, you will get similar

results to everyone else. This means that the only way to get above-average

results in investing is to think/act differently to everyone else AND be correct.

The issue is that even the best investment ideas can take months or years to

pan out, meaning that outperformance in the long-run will almost always have

periods of underperformance in the short-run. At the same time, the worst

investment ideas can take months or years to blow up – meaning that astute

investors sitting on the sidelines will be ridiculed for missing out on the

“easy” money.

Put yourself in the shoes of a portfolio manager that is trying to keep a well-

paying and prestigious job. You can do the same thing as everyone else with

some minor tweaks, earn similar returns to everyone else, then hire a sales

team. If the markets go up, nobody complains and your sales team have an

easy job. If the markets go down, you’re in the same boat as most of your

peers so your sales team can say that nobody saw a sell-off coming. Either

way, it’s not too difficult to keep your job and raise money because you’re not

taking any risks.

But what if you actually tried to earn above-average results? Even if you have

a great investment thesis, you will likely have to undergo months or years of

underperformance – which means your sales team need to convince current

and prospective clients that although you’re currently underperforming, you

may outperform in the future – a difficult pitch. You’re also bound to make

mistakes along the way, which means that the sales team needs to convince

clients that although you lost them money in this instance, you’re going to

make up for it in the future – another difficult pitch.

28

Investing For The Long Run In James Thurber’s classic short story The Secret Life of Walter Mitty, a mild-

mannered man escapes his mundane life by daydreaming that he is a

trailblazing hero. One moment Walter’s wife is reprimanding him for driving

too fast on the highway; the next, he is a courageous pilot WW2 embarking

on a daring mission to attack a German ammunition dump.

Most retail investors have much in common with Walter Mitty when they

estimate their risk tolerance, imagining themselves holding steadfast during a

major crisis without breaking a sweat. More often than not, when push

comes to shove, they aren’t as brave as they thought, nervously monitoring

their bleeding portfolio before capitulating and selling at the worst time.

If our portfolio drops 20%, should we buy more shares? Or do we need to get

out quickly before the 20% loss turns into 40%? After all, every 40% drop

was once a 20% drop! You can hypothesise how you’d act in these scenario,

but to quote Hamlet if he became an investment adviser “Sell-offs make

cowards of us all”. When everyone else is losing their heads, its very hard not

to get caught up!

This is why the platitude “invest for the long-run” is misguided, as the long-

run is a rollercoaster of short-runs. In the last 20 years Australian shares have

averaged 10% returns, but very rarely do you have an “average” year!

Australian Share Returns Since 2000

2000 4.8% 2005 22.3% 2010 1.6% 2015 2.6%

2001 10.4% 2006 24.1% 2011 -11.2% 2016 11.5%

2002 -9.0% 2007 15.9% 2012 19.4% 2017 11.8%

2003 14.5% 2008 -38.8% 2013 19.5% 2018 -3.2%

2004 27.6% 2009 37.1% 2014 5.2% 2019 22.3%

Our goal at Stanford Brown is to help you achieve your financial goals (more

on goals later!) with fewer, shorter, and shallower setbacks along the way.

It’s all well and good to hypothesise how you’d act in these testing scenarios,

but we’d rather avoid them altogether!

29

Art vs Science Marketing guru Seth Godin has written a new post in his blog every day since

2008. This week he provided some career advice that also applies to

investing:

Every golf scorecard has a map of the course on the back. Moving the hole placement is a big deal, accompanied by meetings and oversight. A big shift

is whether or not it rained last week.

On the other hand, every wave is the first and last of its kind. It has never

happened before and will never happen again.

Using Godin’s terminology, investing is more like surfing than it is like golf –

meaning it is an art as well as a science. The science of investing is crunching

data and reading up on history, the art of investing is knowing which lessons

from the past are useful and whether those lessons will be relevant for the

future. Because each market wave is unique, the art is often more important

than the science. Investing by only looking at the past is like driving by only

looking at the rear-view mirror – difficult but doable if the road ahead is

exactly like the road behind, dangerous if and when there is an unexpected

twist in the road!

30

The Rashomon Effect The classic Japanese film Rashomon depicts the unsolved murder of a

samurai, with four conflicting eye-witness accounts of the murder shown to

the viewer. The beauty of Rashomon is that we ultimately never know what

happened, as each account of events is sanitised to present the witness

favourably. The Rashomon effect comes into play when the same event is

given contradictory interpretations, and is of most relevance to investors in

times of heightened volatility. What are we to make of the recent weakness

in shares? If you ask a stockbroker, they’ll likely say December was a

temporary blip and you should take advantage of cheap prices. If you ask a

gold dealer, they might say it was the beginning of the next GFC and you

should take this chance to position your portfolio defensively. Even honest

attempts to explain the movements of markets will always fall short, as there

are too many factors contributing to the trading of hundreds of billions of

shares around the globe each day.

Jack Bogle, the late founder of the Vanguard Group, once wrote that “the

stock market is a giant distraction to the business of investing”. When our

portfolios lose money our natural inclination is to understand what happened.

The takeaway from the Rashomon effect is to keep in mind that all accounts

of short-term market movements are perspectives, rather than explanations,

and more often than not are of little use for long term investors.

31

Herding The renowned American investor Joel Greenblatt was once asked to teach a

class of 9th graders from Harlem about investing. In his first class, Greenblatt

brought a jar of jelly beans and asked each student to inspect the jar and

make an estimate of how many jelly beans there were. After collecting the

initial estimates, he went around the class and asked each student to share

their answer, and gave them the chance to change their estimate.

The average answer from the initial estimate was 1771, an excellent result

considering there were 1776 beans in the jar! The average answer from the

second round of guesses, where the estimates could be influenced by the

opinions of other students, was around 850. Greenblatt told the students that

most investors allow the opinions of others (friends, the media, etc) to

influence their decision making, even though being cold, independent and

analytical leads to greater success.

The lesson to take from this anecdote is the dangers of herding, whereby

investors mimic the behaviour of the crowd. It is human nature to want to fit

in, however human nature dates back to times when we were living in caves,

and is ill equipped for investing in the 21st century. The next time your mate

from the golf club urges you to invest in ‘the next Google’ offer him a jelly

bean!

32

Sequencing Risk There is a growing trend in the US called the FIRE movement, which stands

for Financial Independence, Retire Early. The premise of the movement is

that if you save enough money and can push frugality to its limits, you can

retire in your 30’s or 40’s and live off the passive income for the rest of your

life. Instead of wasting your life working for the man, you can do whatever

you want! (as long as it’s in the 50 year budget that you must adhere to or

else risk destitution).

The face of the FIRE movement is a blogger known as Mr Money Moustache,

who has written that $1m is more than enough for an individual to retire at

35, provided they only spend $40k per year. Here’s the plan, which we’ve

tweaked for an Australian audience:

• Finance the next 25 years of spending by investing $500k outside of

Super and living off income and drawdowns

• Invest $500k in Super at age 35, which will grow to $1.2m by the time

you get to 60

• Live off the $1.2m in perpetuity, as the gains and income from your

portfolio will offset any withdrawals

This is a financial fairy tale. We could write an entire book on the follies of this

plan, however there is one flaw we feel compelled to address – the

assumption that the market will deliver consistent, healthy returns for years

or decades at a time.

Imagine two 35 year olds followed this plan, with Investor A retiring with

$500k in December 2007 and Investor B retiring with $500k in December

2008, investing their savings in the local sharemarket and taking out $10k

each quarter to finance their lifestyle. Thanks to fortunate timing, Investor B is

in good shape to finance their lifestyle until 2033. Investor A, on the other

hand, could earn 4% per month on their portfolio and still not make it to 2022.

33

A unique investing risk for retirees is that most of them rely on their portfolio

to finance their living expenses. This means that they often have to sell

shares during the midst of market downturns, which is one the cardinal sins

of investing. This is known as sequencing risk, and is one of the reasons why

Stanford Brown’s investment process is centred on delivering fewer, shorter,

shallower setbacks. As we can see below, having to make regular

withdrawals means that most retirees don’t have the luxury to ride out

market downturns and enjoy the fruits of long-term investing.

34

Diversification One of the simplest, but often ignored, ways investors can reduce their

chances of suffering catastrophic losses is through investing in a diversified

portfolio. Diversification is so powerful because it reduces exposure to the

idiosyncratic risks inherent in individual investments, allowing for smoother,

less volatile returns.

Imagine an investor puts their entire life savings in CBA, this would leave the

investor exposed to any risks specific to CBA (e.g. key executives leaving).

The investor may then buy the other Big 4 banks to diversify their portfolio,

reducing their exposure to CBA but remaining vulnerable to industry specific

risk (e.g. the Royal Commission). The investor may then buy an index fund

tracking the returns of the Australian sharemarket, but this would still leave

the investor exposed to risks specific to the Australian sharemarket (e.g.

skewed towards banks and miners, small technology sector, etc). The

process of diversification can continue until the investor has exposures to

Australian bonds, American tech, European real estate and everything in

between.

Perhaps most importantly, in addition to smoother returns, diversified

portfolios allow investors to make mistakes. Imagine waking up one morning

and finding your life savings were down 10% because your largest

shareholding lost a major contract. Effective diversification means that you

can retire knowing that your life savings aren’t relying on the fortunes of a

handful of companies. As the old proverb goes: “don’t put all your eggs in

one basket”.

35

The First Bubble Sydney has no shortage of experts on the

property market (roughly four million), with the

subject of housing affordability regularly

debated in living rooms, pubs, TV studios and

everywhere in between. If paying more than

10 times the national median wage for a

house seems absurd to you, imagine paying a

similar amount for a flower.

In the early 17th century, the introduction of

tulips to the Netherlands from Turkey

captivated Dutch society, with a non-fatal virus

that gave the tulips stunning streaks in colour

turning an already rare flower into a widely

sought after asset.

As the price of tulips steadily rose, investors began to speculate on the price

of tulips and soon every man and his dog were selling their assets and taking

on debt to purchase tulip bulbs. In the winter of 1636-37 the already

overpriced tulips had a twentyfold increase in value. Historian Mike Dash

spoke of the sale of a single Semper Augustus bulb (pictured) in 1637 “It was

enough to feed, clothe and house a whole Dutch family for half a lifetime, or

sufficient to purchase one of the grandest homes on the most fashionable

canal in Amsterdam for cash”.

Unsurprisingly, the price of tulips plummeted shortly after as few could afford

to pay such exorbitant amounts for a flower with little intrinsic value. This

story is a pertinent example of the “greater fool” theory of finance in which

investors buy an asset not because it is a sound investment, but because

they believe another investor will pay a higher price for the asset.

36

Short Selling Subscribers to the financial papers might often read about a company

coming under pressure from short sellers, but what exactly is shorting?

Put simply, short selling is a strategy used by investors to profit from

declines in the price of an asset. A short seller of shares borrows shares

from a broker (usually paying a commission) and is obliged to return

those shares at a predetermined point in the future. The short seller

hopes that they can sell shares of a company today, then buy the same

number of shares for a lower price in the future when they have to

return the shares back to the broker.

Thanks to the cornucopia of financial instruments available in the

market, investors can short sell companies, share markets, coffee and

even the housing market. In 2005 Michael Burry, a hedge fund manager

who was portrayed in the 2015 film “The Big Short”, shorted mortgage

backed securities, which rely on income from mortgage owners making

their monthly repayments. When the subprime mortgage bubble

eventually burst in 2007 (causing the Global Financial Crisis), the price of

mortgage backed securities plummeted, and Burry pocketed a cool

$3.7b for his clients.

37

Alas, as with every other investment, one must weigh the potential

returns of an investment with its risks. Short sellers usually identify

investments they believe are overvalued and bet on other investors

reaching the same conclusion and selling. Although this may seem like a

sound strategy, it is not without peril. Many hedge fund managers made

the same bet as Michael Burry but ended up going broke because they

made the bet too early. To re-use a quote from famed economist John

Maynard Keynes “the market can stay irrational longer than you can stay

solvent”.

38

Skepticism Have you ever read a newspaper article on a subject of which you have some

expertise and then realised that the journalist has no idea what they’re talking

about? More often than not, we’ll wonder how the article managed to make it

past the editor but then read the next article without considering whether it

will be similarly error-ridden! Jurassic Park author Michael Crichton labelled

this phenomenon as the Gell-Mann amnesia effect.

This can often lead to individuals who are brilliant in their professional domain

making elementary errors when investing. A physician can scoff at an article

about a fad diet, but may read an article about a fad investment a few

moments later and actually consider the idea.

The lesson for investors is to remember that financial news is just as error

ridden, if not more, than the rest of the news. As Mark Twain famously wrote

(or did he?) “If you don’t read the newspaper you are uninformed; if you do

read the newspaper you are misinformed”.

It is our job to help you distil the signal from the noise.

39

Timing The Market

Whenever equity markets fall, a few nervous investors get on the phones

and ask us to sell their shares. One common justification for this

misguided (but understandable) strategy is “If I sell now, I can buy even

more shares at the bottom!”. Which begs the question – If the investor

has such great insight into timing the market, why did they wait until after

the sell-off to sell their shares?

Unsurprisingly, the investor in our example is not the first person to try

and time the market. Millions of academics, institutions, professional

investors and amateur investors have spent countless hours trying to

formulate a strategy that can predict the direction of markets. And for

good reason too. An investor who could correctly time the daily

fluctuations of the S&P 500 would have turned one dollar in 1993 to just

under a sextillion (a billion trillion) dollars in 2015! Unfortunately, it is

unlikely that Stanford Brown will ever have this model in its arsenal. If we

do develop such a model, we are likely to be found aboard our 1,000 foot

yachts.

40

Patience When their life savings are at stake, it is only natural for investors to

continually monitor their portfolio to ensure that everything is running

smoothly. As with most things investing however, doing what feels natural is

a recipe for underperformance.

In his seminal work “Thinking, Fast and Slow”, Nobel Prize winning

behavioural psychologist Daniel Kahneman wrote that “Closely following daily

fluctuations is a losing proposition, as the pain of the frequent small losses

exceed the pleasure of equally small gains”. This the Loss Aversion bias in

action, which we have covered in a previous Finance 101. Most investors will

check their portfolios after reading hysterical headlines in the financial papers,

which is why they would be better off avoiding financial publications (with the

exception of TW3, of course).

So how often should you check your portfolio? In the words of one money

manager “If you own growth stocks, you should only look at the price every

12 months. That way, you’ll only suffer one sleepless night a year”.

Successful investing requires a degree of patience that most people simply

do not have, which is why one of the key roles of a financial adviser is to

simply guide you through the inevitable twists and turns of the sharemarket.

To quote Warren Buffett “The stock market is a device for transferring money

from the impatient to the patient”.

41

Recency Bias When engaging a financial adviser, most investors will be asked a number of

risk-profiling questionnaires that go along the lines of “On a scale of 1-5, how

comfortable would you be with a 20% loss in your portfolio”. Investors tend

to overestimate their comfort with risk when answering these questions, in

large part thanks to the recency bias.

The recency bias occurs in investing when we look at the recent past to

predict the future. If the market has been trending up recently, we usually

expect the market to continue doing so. When the market has sold-off

recently, we usually expect the market to continue trending downward. Of

course, this line of thinking is flawed, but that doesn’t stop it from creeping

into our psyche.

We tend to overstate their comfort with investment risk because the future is

uncertain. Nobody knows for sure how deep a sell-off will be nor how long it

will go for. If you knew for certain your portfolio was going to drop by 20%

then rebound in 3 months, you probably wouldn’t bat an eyelid. But when

you’re in the midst of the sell-off and your portfolio is bleeding, the recency

bias creeps in and we’re likely to wonder whether we should sell-out and

avoid the rest of the downturn.

The true value of an adviser isn’t to deliver a flawless strategy, but rather to

help you stick to the plan when you feel the urge to make drastic changes to

your portfolio. There are few emotions quite as rich as losing important

money, and our advisers are here to help you resist the urge to make

common mistakes that guarantee underperformance.

42

Probability vs Possibility

Clickbait <noun> (klik-ˌbāt): something (such as a headline) designed to

make readers want to click on a hyperlink, especially when the link leads

to content of dubious value or interest.

Financial papers make most of their money by selling advertising space.

The more internet traffic they can generate, the more valuable their

advertising space becomes. The easiest way to achieve this result is to

use outrageous headlines to goad readers into clicking the article.

The headline below is a classic example of clickbait. In the article,

Australian hedge fund star John Hempton claimed that houses in the

outer suburbs of Newcastle could fall by up to 85%. You also could win

the lottery tomorrow, you could even win it twice! Since there are an

inconceivable amount of possible future outcomes in life, we should

focus on what’s probable rather than what’s remotely possible.

43

Having a healthy dose of scepticism also helps in our personal lives. Any

time you hear “can”, “could”, or “may”, remember that you are now

talking about what’s possible rather than what’s probable. Take for

example these 7 “scientifically proven” benefits of Vitamin C

supplements. Do they sound very conclusive to you?

But don’t take our word for it! It is scientifically proven that reading TW3

regularly may result in higher levels of intelligence, attractiveness and life

satisfaction!

44

Survivorship Bias If you had invested $1000 in Amazon when it listed on the NASDAQ in 1997,

you’d be sitting on just under $900,00! Imagine if you had the foresight to

know the potential of the internet back in 1997 and had invested in Amazon!

When daydreaming about missed investment opportunities like Amazon, it is

important to keep survivorship bias in mind. Survivorship bias occurs when

we only consider success stories and forget about the companies that failed.

As it turns out, lots of people thought that the internet was going to be a big

thing in the late 90’s and early 2000’s, creating one of the largest speculative

bubbles in history. For every Google and Amazon, there were dozens of

companies like Webvan, Pets.com, and eToys.com which went into

bankruptcy once the speculative party was over. Who’s to say that if you had

your time again you would’ve chosen Amazon over one of these lemons?

One of the many lessons from the dot-com bubble is that it is not always a

good idea to invest in a company just because it is in a booming industry. We

often have clients ask whether they should invest in solar since it’s “the next

big thing”. Even if that’s true, you need to make sure you’re investing in the

next Amazon rather than the next Webvan!

45

Risk vs Uncertainty A simple yet important distinction for investors to make is the difference

between risk and uncertainty. Risk is where there are a known number of

outcomes that may occur in the future, and we can try to assign probabilities

to make an estimated guess. Uncertainty is where we don’t know what may

happen in the future, making it difficult to make predictions about the future.

If you bet $100,000 on the roulette table, you are dealing with risk but not

uncertainty. You are risking that the number the ball lands on is different to

the one you wagered on, but you know exactly how many numbers are in the

roulette wheel.

If you invested $100,000 in shares, you are now dealing with uncertainty.

Trump’s antics this year are a perfect example of that. Will he raise tariffs? On

who? By how much? When? For how long? Will he compromise? Is he

bluffing? Will the other country retaliate? How will he retaliate to the

retaliation? These are all questions that affect investor sentiment and

therefore share prices, yet nobody can be reasonably certain what the

answers to these questions are. This is just one of thousands of pertinent

variables that affect share prices which display uncertainty.

So how do we deal with uncertainty? It helps to have the humility to admit

there is uncertainty! Every now and again a new team of brilliant investors

armed with PhD’s in astrophysics and quantitative finance will claim that

they’ve mastered the markets, only for them to inevitably go down in flames

(e.g. Long Term Capital Management).

At Stanford Brown we deal with uncertainty by focussing our efforts on

managing our clients’ exposure to risk. We do not promise astronomical

returns, nor do we guarantee that every year will be a smooth ride. What we

do promise is that we will diligently manage your portfolios with the

underlying aim of achieving your financial goals with fewer, shorter and

shallower setbacks.

46

Animals in Finance As the Royal Commission illuminated, there are plenty of animals in finance.

Even if the Hayne Report is implemented, there will still be some animals

walking about. Here is the TW3 guide to animals in finance:

Animal Spirits – The natural instincts and biases that cause investors to act in

an irrational manner (e.g. fear and greed)

Bulls – An optimistic investor that believes prices will rise in the near-future.

Investors who always believe prices are going to go up, despite risks of a sell-

off, are known as permabulls

Bears – A pessimistic investor that believes prices will fall in the near-future.

Investors who consistently predict a major crash around the corner are known

as permabears

Gold Bugs – Investors who are consistently bullish on gold as an investment.

Gold bugs are usually permabears, often citing hyperinflation and the

impending collapse of the global monetary system as reasons to own the

precious metal

Chickens – Investors who are unreasonably risk averse, earning sub-par

returns due to their overly conservative investing

Pigs – Investors who take on too much risk, often out of greed. No return is

good enough for a pig, who will often borrow money to supercharge their

returns (and more often than not, their losses)

Hawks – A monetary policy hawk supports tighter monetary policy (i.e. higher

interest rates), often wanting to keep a lid on inflation and debt levels

47

Doves – A monetary policy dove supports looser monetary policy (i.e. lower

interest rates), claiming that cheaper debt will stimulate spending &

investment and boost employment

Ostriches – Investors that ignore negative information about an investment

rather than reassessing their position (e.g. a cryptocurrency investor assuring

themselves a regulatory crackdown will have no effect on the value of their

coins)

Sheep – Investors that look to others to guide their decision making. These

investors often act on investing tips from friends & family, or buy whatever

fad investment is trending. They are doomed to underperform, buying when

prices are high and selling when prices are low

48

Commodities A staple of Australian business reports in the evening is an update on

commodity prices. This is a result of Australia supplying 50% of the world’s

iron ore, 38% of the world’s coal and billions of dollars of other raw materials

such as natural gas, gold and aluminium. Around 60% of Australian exports

are unprocessed, meaning that we are reliant on other countries buying our

natural resources and doing something productive with them.

A commodity is a good that is highly fungible, meaning that it can be easily

substituted. Because Australia is primarily in the business of exporting

commodities, domestic growth is highly linked to the global economic

business cycle. Although supporters of Kevin Rudd may claim his $42b

stimulus package staved off a recession in 2009, China’s $875b stimulus

program centred on infrastructure spending spiked a rebound in the prices of

key commodities such iron ore, coal and aluminium, kickstarting economic

activity in Australia. As long as China continues building ghost cities, the

economy “should be right”.

Although some call Australia “The Lucky Country” as a term of endearment,

the author who coined the term used it in the pejorative, claiming that

Australia’s prosperity was a result of luck (abundant natural resources,

distance from major theatres of war, inherited British political system, etc)

rather than ingenuity or industriousness.

49

In some ways it was unfortunate that Australia did not fall into recession

after the GFC, as no impetus was provided to make major economic reforms

– after all, if it ain’t broke why fix it? The great mining boom that started in

2003 has masked a number of structural flaws in the Australian economy,

which are only now starting to be noticed as the boom wanes.

The great economic reforms of the 80’s and 90’s were borne from necessity,

and fortunately we had leaders from both sides of the political aisle bold

enough to implement them. When we inevitably fall into recession again, we

hope our current crop of leaders will be able to follow suit!

50

The Australian Sharemarket When we refer to “Australian shares” during each week’s market wrap, we

are generally commenting on the performance of an index (typically the ASX

300 or All Ordinaries), but what comprises these indices? We have broken

down the ASX 300 by industry, classifying each one as cyclical (outperforms

in good economic times and underperforms in bad economic times) or

defensive (underperforms in good economic times and outperforms in bad

economic times).

• Financials (34% of ASX 300) – Companies that engage in financial

services such as banking, insurance and asset management. Real

estate investment trusts (REITs) are also considered as Financials.

Financial stocks tend to be somewhat cyclical, as few people are

looking to borrow more money or take out a new insurance policy

during an economic downturn. Examples on the ASX: the Big 4 banks,

Scentre, Goodman, IAG.

• Materials (25% of ASX 300) – Companies that manufacture and

distribute raw materials and commodities. Australia’s largest exports

are iron ore and coal, the demand of which is heavily dependent on the

business cycle. Examples on the ASX: BHP, Rio Tinto, Fortescue,

Newcrest, Amcor.

• Healthcare (9% of ASX 300) – Companies that manufacture healthcare

equipment/supplies, provide healthcare services or are engaged in

pharmaceutical or biotechnology. Healthcare stocks tend to be

defensive, since people get sick irrespective of what’s happening in the

economy and require healthcare services. Examples on the ASX:CSL,

Resmed, Ramsay, Cochlear, Fisher & Paykel.

• Industrials (8% of ASX 300) – Companies that distribute capital goods

(e.g. heavy machinery), construction/engineering services, commercial

services and transportation services. Industrial stocks in Australia tend

to be cyclical, as many of them provide goods and services to mining

companies which are highly cyclical. Examples on the ASX: Transurban,

Sydney Airport, Qantas, CIMIC.

• Consumer Discretionary (7% of ASX 300) – Companies where the

consumer is making a purchase out of choice rather than necessity. For

example, if you have a roadworthy car you don’t need to buy a new

one, but may choose to anyway. Consumer Discretionary stocks are

tightly linked to the business cycle, because when times are tough

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consumers tend to cut unnecessary spending (e.g. holding off on

buying the new car). Examples on the ASX: Harvey Norman, Flight

Centre, Crown Resorts.

• Consumer Staples (5% of ASX 300) – Companies where the consumer

will have demand for the product irrespective of economic conditions. It

doesn’t matter whether the economy is roaring or in the depths of

recession, people need groceries, toothpaste and toilet paper.

Consumer Staples stocks tend to be seen as defensive, as their sales

aren’t tightly linked to the business cycle. Examples on the ASX:

Woolworths, Coles, Coca-Cola Amatil.

• Energy (4% of ASX 300) – Companies that are engaged in providing

energy/fuel or exploring and refining energy sources. Energy companies

tend to be somewhat defensive, as energy is in constant demand.

Examples on the ASX: Woodside Petroleum, Santos, Caltex, Oil Search.

• Communications (3% of ASX 300) – Companies that provide telephone,

internet and other communication services. Communications stocks

tend to be defensive since their products are in constant demand.

Examples on the ASX: Telstra, Spark New Zealand, TPG, Vocus.

• Information Technology (3% of ASX 300) – Companies that offer

software/IT services or manufacture and distribute technology

hardware. IT stocks around the world are at sky-high prices as investors

bet that earnings growth will continue to be robust, meaning that they

are likely to underperform during the next sell-off. Examples on the

ASX: REA Group, WiseTech, Xero, Domain.

• Utilities (2% of ASX 300) – Companies that supply electricity, gas and

water to the broader public. Utilities tend to be defensive given the

constant demand for their product and high barriers to entry from

competitors. Examples on the ASX: AGL, Origin, APL, Spark

Infrastructure

What you may have noticed is how top heavy the Australian market is, with

Financials and Materials accounting for roughly 60% of the ASX 300. The

largest company in Australia today is BHP, which at 9% ($200b AUD)

accounts for a greater share of the ASX 300 than all but two sectors, and the

top 10 stocks in the ASX 300 are worth more than the bottom 277 combined!

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Silly Stimulus It would appear that billions of dollars in tax refunds and two interest rate cuts

is not enough stimulus for some observers, with the Council on the Ageing

and Deloitte Access Economics recently calling for an increase in the

Newstart allowance to kickstart the economy. The argument is that

Australians receiving Newstart are likely to spend their additional income

straight away, whilst many Australians receiving their tax cuts will use their

tax cuts to lower their debts or add to their savings.

We could also stimulate spending and reduce unemployment by paying

jobseekers to dig holes then fill them back up. This would no doubt generate

some economic activity, but does this seem like the best way to spend

taxpayer money? Does it address the underlying factors causing economic

stagnation in the first place? Increased spending should be a by-product of

effective fiscal policy (e.g. improved highways facilitating more interstate

commerce) rather than an objective of fiscal policy.

Whether Newstart is sufficient to maintain a decent standard of living is a

separate issue. But increasing it for the express purpose of economic

stimulus is misguided, if not dangerous!

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Subjective Value We’ve all heard that beauty is in the eye of the beholder, but what about

value? Is a $50 schnitzel a good deal? If you hadn’t eaten in a week you’d

probably pay hundreds of dollars for a meal, so $50 would be a bargain. If you

were a devout vegetarian, the world’s finest schnitzel could be offered to you

for $1 and you would decline. This is just one example of subjective value,

where the value of a good can vary from person to person depending on their

preferences or circumstances.

Subjective value when it comes to finance is known as investment value,

referring to the value of an asset for a particular investor. Why would a house

in Balmain sell for $1.5m when its market value is $1m? Perhaps their

neighbour thinks they can sell the combined properties to a developer and

make $750k, so they would be happy to overpay by $500k.

A young investor and a retiree will pay the same price for Afterpay and

Telstra, yet the chances are that they will value those stocks differently. The

young investor will likely value capital gains over dividends, so they would

likely avoid Telstra shares even if they were offered at a discount. Conversely,

the retiree will likely value a steady income stream over capital gains and

would thus have little desire to invest in Afterpay.

Since the value we derive from investments can vary wildly, a one size fits all

approach to financial planning will often be flawed. At Stanford Brown we

believe that a holistic approach to managing your finances is not only the best

way to achieve your financial goals, but to maximise your wellbeing. In the

wise words of Forrest Gump after finding out he doesn’t have to worry about

money anymore – “that’s good, one less thing!”.

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Rear View Mirror Investing One of the most common (and costly) mistakes retail and professional

investors make is to look to the past to predict the future. We tend to be

much more comfortable buying an investment that has been trending

upwards than downwards - we love paying less for clothes (more on that

below) but love to pay more for shares!

This phenomenon is known as rear view mirror investing, where our

investment decisions are mostly guided about what has happened in the past,

rather than what is likely to occur in the future. This is akin to driving a car by

looking in the rear view mirror, which in the words of hedge fund manager Ed

Wachenheim “is ok while the road remains straight, but a catastrophe when

the car comes to a curve".

The GFC was largely caused by bankers lending too much money to broke

people so that they could buy a house. The logic was that it didn’t matter if

the borrower defaulted on their mortgage, because there had never been a

nationwide decline in house prices in America (and therefore there wouldn’t

be one in the future) so the bank would easily be able to find a new borrower

or sell the house at a profit. As it turns out, house prices can indeed go down

in unison if there is enough recklessness and speculation, and the global

economy would shortly pay a heavy price for the excesses of the subprime

mortgage boom.

The performance of an investment purchased today depends entirely on

future events, or more specifically – how other investors respond to future

events. An encyclopaedic knowledge can help an investor understand what

has driven markets in the past, but one must always remember that history is

not guaranteed to repeat itself. In the words of Warren Buffett “If history

books were the key to riches, the Forbes 400 would consist of librarians".

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Opportunity Cost One of the most powerful concepts to grasp in economics and finance is

opportunity cost. Opportunity cost refers to the value of alternative uses of

our time and money that we forego when we choose how to utilise those

resources.

For example, the opportunity cost of spending $200 to go to the Bledisloe

Cup with a friend is the alternative uses of that $200. It could be spent on

groceries, clothes, or it could be invested or used to pay off an outstanding

debt. We can also apply opportunity cost to the way we spend our time. Any

time we spend doing an activity or task could be spent on a myriad of other

activities or tasks.

Of course, there is much more to our decision making than maximizing

monetary gain and efficient time usage. Going to the Bledisloe Cup won’t

achieve either of these things, but you’ll probably have a great time. Unless

you’re a Wallabies supporter, in which case you’ll likely writhe in

disappointment and despair.

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The Importance of Free Trade If you are sitting at your desk, grab hold of a pencil.

Appreciate for a moment that there is not a single person in the world who

knows how to make that pencil. The wood of the pencil had to be cut from a

tree. To cut that tree, a saw had to be used. To create that saw, iron ore had

to be mined, smelted, and formed into shape. The graphite interior of the

pencil could have come a mine in China, India, Brazil or Canada. The eraser,

the adhesive that secures the eraser, the paint that colours the pencil and all

the other inputs of the pencil were sourced from the labour of hundreds, if

not thousands, of people across the globe.

The creation of the pencil, the screen you are reading from, the dinner you’ll

eat tonight, and almost every other possession you have is the cumulative

result of millions of transactions between economic agents. People of

different cultures, creeds and races peacefully trade with each other every

day – the beauty of a free market system is that you or I don’t need to know

how to raise a crop of vegetables, build a car or program a computer in order

to gain access to them.

The current swell of discontent with the free market economy is misguided

and self-destructive. The free market economy built the world we live in, and

rolling it back in the hope of creating more jobs is an archaic measure guided

by fear and specious reasoning.

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Ceteris Paribus When you hear a politician claiming the economic benefits of a policy, the first

thing you should think is “ceteris paribus”. Translated from Latin, ceteris

paribus simply means ‘all else being equal’, a critically important concept to

bear in mind when considering the forecasts of politicians, economists and

everyone in between.

Unlike the natural sciences, where experimenters can isolate variables to test

hypothesises, it is near impossible to make definitive claims in the social

sciences such as finance, economics and political theory since human

behaviour is too complex. To deal with this, we can use qualifiers such as “all

things being equal”. This is of little use, however, as all things are never

equal, and often what ends up happening is the opposite of what we’d

expect. For example, when a new road is built, traffic usually gets worse (as

more people drive instead of using public transport) and when petrol prices go

down, travellers often spend more money on petrol (as they can afford to

drive more).

In one example, the Australian government hoped to raise $200m through a

digital tax on online retailers. The tax may have raised that much if the policy

had no effect on the sales and business strategies of the companies being

taxed, or all things being equal. Unfortunately for the treasury (and Amazon

customers), Amazon announced that it would be blocking Australian users

from using its US store as a result of the tax.

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Loss Aversion One of the most important skills required for successful investing is knowing

when to cut your losses and sell an underperforming investment. Many

investors shoot themselves in the foot by refusing to cut their losses,

insisting on holding on to losers in the hope that they’ll ‘come good’. This

mistake is a form of the behavioural bias known as loss aversion, where

individuals are more sensitive to losses than gains.

The American financial planner Carl Richards likes to pose the following

question to test whether investors are allowing biases to creep into their

decision making: if an administrative error mistakenly sold your portfolio down

into cash, would you buy the same portfolio you hold today? If the answer to

that question is no, you need to consider whether you’re holding some

investments for the wrong reasons.

In no way are we advocating selling just because an investment undergoes a

period of underperformance. Rather, understand the difference between

having conviction and hoping for a reversal of fortunes. No investment goes

up in a straight line and a great deal of patience is required for successful

investing. As Warren Buffett once said “the stock market is a device for

transferring money from the impatient to the patient”.

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Prospect Theory As we wrote last week, humans are by nature more sensitive to potential

losses than they are to potential gains. This attribute is a result of evolutionary

psychology, where our ancestors could pay dearly if they weren’t risk averse

(was that noise in the bushes a tiger or the wind?). So strong is our aversion

to loss, we will often risk additional pain in order to avoid a certain loss.

We would expect that an investor who sells for a $1500 profit will be equally

happy as an investor who could have sold for $2000 but then sold for $1500.

However, according to prospect theory, the second investor will be less

happy because they feel like they have lost money. So strong is our loss

aversion that investors given $2000 would rather risk take a 50/50 chance of

losing $1000 than they would a 100% chance of losing $500. Psychologist

Dan Kahneman, in his seminal work Thinking, Fast & Slow, demonstrated that

retirees fear losses five times more than they enjoy gains.

The lesson to draw here is to be objective when analysing investment

outcomes. One of our editors has many friends who invested heavily in

cryptocurrencies, and if they sold today they would have doubled their

money. However, many of them remain invested because they didn’t sell at

the peak of the market, where they could have increased their money tenfold.

Despite the underperformance of cryptocurrencies, they still hold on because

they think selling at any price below the previous peak is a loss, risking their

current profits in the hopes that prices will rebound.

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Hindsight Bias When reviewing our portfolios, it is natural to think to ourselves that it would

have been great if we had put more money in our best performing

investments and sold the underperforming investments, or if we had invested

more in Sydney property in 2012, or bought Bitcoin in 2009. Whilst it’s true

that making those investments would’ve made us rich in the past, there’s no

guarantee that they will make us rich in the future.

High returns are almost always accompanied by high risks, however when we

read about a stock that’s up 50% there is rarely a footnote disclaiming that it

was an incredibly risky investment. This feeds into a behavioural bias known

as the hindsight bias, where investors believe that past events (such as a

stock going up 50%) were obvious and predictable.

Long-term investing is not gambling, however it is akin to gambling in the

sense that we are putting money at risk based on our predictions of the

future. We doubt any readers watched the Melbourne Cup last year and

thought it would’ve been a good idea to risk their life savings on the winning

trifecta.

Since we can’t predict the future, the best we can do is to have a sound

investment process that mitigates the risks in our portfolio. This will not

always lead to spectacular gains, but it is our best shot of avoiding

catastrophic losses. When comparing the returns of our portfolio to other

investments, we must keep in mind how risky the other portfolio is.

If 24 people each risk their life savings on a horse in the Melbourne cup, one

person will walk out a multi-millionaire whilst the remaining 23 will be

destitute. To whom should we compare our returns? Every investor who took

a large risk? Or only the ones whose risk paid off?

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Action Bias Let’s imagine the share market drops 10% next month. What should we do?

Maybe we should reallocate to bonds to reduce risk, or perhaps we should be

more aggressive and buy stocks, or perhaps we should sell it all and invest in

some of that bitcoin that keeps popping up in the papers. It is natural to want

to make adjustments every time we see an opportunity for loss or an

opportunity for profit, but often the most profitable action is to sit on your

hands and do nothing.

The desire to make constant portfolio adjustments is known as the action

bias, and more often than not it results in subpar returns for investors. This is

mostly due to the fact that investors will generally only make changes to their

portfolio once it’s too late. Although this may seem obvious, the time to

adjust your portfolio is before the 10% dip in stocks, not after.

Why is this? Most often it is due to another bias known as the projection bias,

whereby investors assume that what’s happened in the recent past (e.g. a

10% drop in shares) is likely to occur in the future. More often than not, this

will not happen and the market will rebound, and the investor will start

wondering whether they should readjust again and restart the action bias

cycle.

A couple of quotes for you to ponder:

“Time is your friend, impulse is your enemy” – John Bogle (founder of

Vanguard)

A famous quote from Mr. Buffett is one of our favourites – “lethargy

bordering on sloth reflects the cornerstone of our investment style.”

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There’s Nothing Riskier Than Cash Most investors think of risk in terms of potential short-term losses (for

example, the risk that the stock market may drop 10% in the next quarter).

However few think of risk in terms of not achieving our long term investment

goals (e.g. not having enough money to fund your retirement). The latter risk

is far more harmful than the former.

You may have some friends who keep their savings in cash accounts,

preferring them to stocks since “there’s no risk”. If we use the short-term

measure of risk, they are correct, since the Australian government guarantees

bank deposits. However, using the long-term measure of risk, they are

actually investing in the riskiest asset of all, since cash is the only asset

guaranteed to lose purchasing power after inflation (the cost of living) in the

long run…

Source: Global Financial Data, AMP

The graph above shows that $1 invested in 1900 in a portfolio of Australian

shares has now grown to an eye-popping $280k, whereas that same dollar

placed in a cash account is now worth just $204. Truly astonishing.

Unless you already have all the money you need for your retirement, you will

need to accept the risk of temporary short term losses in order to maximise

the chances of reaching your investment objectives. At Stanford Brown, we

construct portfolios with the overarching goal of meeting our clients’ long

term investment objectives with fewer, shorter, and shallower setbacks.

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The Complexity Bias Financial markets are incomprehensibly complex, with thousands of price

developments, released reports and breaking news stories flooding the

market with every passing moment. More than half of share trading is

executed by complex algorithms and high-frequency trading, whilst the other

trades are made by humans, who introduce their own unique irrationalities

and flaws into the marketplace. In light of this overwhelming complexity,

some investors may think that an equally complex investment plan is required

to navigate this complicated landscape. More often than not, however,

complex strategies leave investors with lighter pockets.

Complex investment strategies appeal to investors thanks to the complexity

bias, where complex solutions are seen as superior to simple solutions.

Financial advisers, fund managers and other investment professionals often

feel compelled to offer complex investment strategies in order to justify their

fees, even if a simple solution is more effective and appropriate.

Complex investment strategies often lead to investors thinking they know

more about markets than they really do, which can lead to them taking too

much risk. Long Term Capital Management was a hedge fund founded in

1994 that had seemed to have mastered financial markets, boasting two

Nobel Prize winners and averaging 40% returns. When the Asian financial

crisis hit in 1998, the fund lost 94% of its value in four months, and had to be

bailed out by the Federal Reserve.

Even the best and brightest minds in finance can blow it all up.

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Although Stanford Brown’s research process is comprehensive, its

investment strategy is relatively straight forward: Hold a diversified portfolio,

adjust asset allocations once or twice a year, and be patient. Whilst this may

not be the most exotic strategy, it’s the one that gives you the best chance of

reaching your financial goals!

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Compound Interest Would you rather have $1m today or earn 100% on one cent every day for 30

days?

If you chose $1m, you’ve left more than $4m at the table!

The example above demonstrates the power of compound interest, where

small increases accumulate over time to create large increases. Compound

interest is so powerful because as you earn interest on your earnings, you can

reinvest to earn interest on your investment, and so on so forth. A million

dollars invested at 10% over 20 years grows to $6.73m, $2m of which is from

interest earned on original $1m, with $3.73m coming from re-investing that

interest.

Einstein once remarked that compound interest was the 8th wonder of the

world. What undoes scores of investors is that they want to get rich quick,

take too much risk, then get burned and are scared to invest again. The surest

road to wealth is to invest sensibly, then sit back and let compounding work

its magic. Of Warren Buffet’s $85b USD net worth, $84.7b USD was earned

after his 50th birthday. If compounding is good enough for Warren it’s good

enough for you!

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The Maths of Gains and Losses If your portfolio was up 55% one year then down 40% the next year, would

you be happy with the outcome? Although on face value it seems like your

portfolio would be up 15%, in reality you’d be down 7%!

Imagine that you have a $1m portfolio. If you gained 50% on that portfolio

you would have $1.5m, but if you subsequently lost 50% you would be down

to $750,000! A 50% loss on a portfolio requires a 100% return to breakeven.

The lesson to glean from this simple arithmetic is that losses do more harm

to a portfolio than gains of an equivalent percentage, therefore it is more

important to avoid major losses than it is to chase small gains. The soon to be

longest bull market in history is beginning to lose steam, however many

investors are happy to keep their chips on the table, hoping that the party will

keep on going for one last dance. Perhaps they should keep a Shakespeare

quote in mind - “When clouds appear, wise men put on their cloaks”.

Balance % loss Balance after loss Gain required to breakeven

$1,000,000 -5% $950,000 5.26%

$1,000,000 -10% $900,000 11.11%

$1,000,000 -15% $850,000 17.65%

$1,000,000 -20% $800,000 25.00%

$1,000,000 -25% $750,000 33.33%

$1,000,000 -30% $700,000 42.86%

$1,000,000 -35% $650,000 53.85%

$1,000,000 -40% $600,000 66.67%

$1,000,000 -45% $550,000 81.82%

$1,000,000 -50% $500,000 100.00%

$1,000,000 -55% $450,000 122.22%

$1,000,000 -60% $400,000 150.00%

$1,000,000 -65% $350,000 185.71%

$1,000,000 -70% $300,000 233.33%

$1,000,000 -75% $250,000 300.00%

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Value and the Greater Fool Theory One of the most important distinctions in Finance is the difference between the

price paid for an investment and the value of the underlying investment. Warren

Buffet once quoted that “price is what you pay; value is what you get”. When an

investor is buying a share, they are buying ownership of a business. When an

investor buys government bonds, they are buying debt from the government.

Although it is an imperfect science, investors can try to calculate the intrinsic

value of an investment (e.g. estimating what the fair price of the share of a

business is given its underlying assets) then try to buy it at a price lower than its

value. This is known as value investing.

Although this is a sound long-term strategy,

it is not without its pitfalls. For starters,

value is subjective. Even if it was selling at

a heavy discount, a vegetarian is unlikely to

buy a steak since they don’t value it

personally. Likewise, a retired investor is

unlikely to buy a highly speculative stock

even if it is selling cheaply because they

don’t want that risk in their portfolio.

Furthermore, two otherwise identical

investors could be given the same

information about an investment and come

to wildly different conclusions about its fair

value, and it is not guaranteed that an

undervalued investment will ever return to

its fair value.

Although value investing isn’t perfect, risk-astute investors need to be aware of

the relationship between the price they are paying for their investment and its

underlying value. Bubbles begin to form when investors buy investments with no

regards for their value. Many investors bought into cryptocurrencies not because

they knew anything about blockchain and its potential, but because they saw the

price rising and thought they could make an easy dollar. Likewise, many

Sydneysiders bought property at eye-watering prices with no consideration for

rental vacancies or interest rates because they saw the market roaring and

wanted a piece of the action. This thinking is known as the greater fool theory,

where investors don’t care about the price they are paying for an investment

because they think someone else will come along and buy it at a higher price.

Although considering value is no guarantee of an early retirement, having no

consideration of value will almost certainly result in a postponed retirement.

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69

The Behaviour Gap A growing subject of debate in finance is whether investors are better off

investing in an index fund rather than paying fund managers who struggle to

beat the market consistently. After all, if we invest in an index fund, we’ll get

the return of the market, right?

Not necessarily! In order to achieve the market’s return, investors would have

to sit on their hands, which goes against every impulse and behavioural bias

they have. The average American investor underperformed the S&P 500 by

2.89% p.a. from 1996-2016, with a significant part of that underperformance

due to ill-advised trades arising from fear, greed and trying to guess the short

term direction of the market.

The difference between the return an investor would have received if they sat

on their hands and the return they actually receive is known as the behaviour

gap. Compounded over time, this gap drastically alters investor outcomes

(that 2.89% compounded over 20 years is more than 75%).

Source: Dalbar

So how do we bridge the behaviour gap? Education and experience are a

good start, but even seasoned industry veterans have behaviour gaps. One of

the key functions an adviser plays is to take the burden of investing off their

clients’ hands, meaning that when major events like the Trump election

occur, investors don’t get spooked by the media’s hysteria and sell at the

wrong time (global shares are up 40% since the Trump election).

In the words of one money manager: “If you own growth stocks, you should

only look at the price every 12 months. That way, you’ll only suffer one

sleepless night a year”

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The GFC The 15th of September 2018 marked 10 years since the collapse of the investment

bank Lehman Brothers, the largest bankruptcy in US history. The sudden demise of

the world’s fourth largest investment bank triggered a full-scale panic in global

markets, with many believing that the world as we knew it was ending. But how did

we get there?

The Global Financial Crisis (GFC) had its

roots in the US residential property market.

Low interest rates and loosened

regulations to promote home ownership

created a white hot property market in the

US, and everyone (even those who

couldn’t afford a mortgage) wanted a piece

of the action. Banks didn’t want to have too many mortgages on their books, so

they hired investment banks to sell their mortgages to investors by creating new

products called mortgage-backed securities, which combined thousands of

mortgages into an investable asset. These new products sold like hot cakes, with

investors paying top dollar for a high yielding investment that was “as safe as

houses”.

This is where things begin to go awry. Banks needed to underwrite more mortgages

to create more mortgage-backed securities, and since they were going to get the

new mortgages off their books ASAP, the banks no longer cared whether the

mortgage applicant was able to pay off their mortgage. Banks started to loan money

to anyone, even those with no income, no job and no assets (known as NINJA

loans). The rating agencies hired to grade the risk of the mortgage-backed securities

all rated them as safe as government bonds, since they would lose the bank’s

business if their report was anything but glowing. Pension funds, retail investors,

foreign banks and everyone in between loaded up on mortgage-backed securities,

assuming that they were investing in an asset that was as good as risk-free. The

entire world had essentially bet the house that US home prices would keep on rising

forever, and the regulators were asleep at the wheel.

Then the music stopped. Interest rates began to rise and tens of thousands of

homeowners began to default on their mortgages. The value of the mortgages

underlying the mortgage-backed securities plummeted in value, and now the

biggest institutions in the world were facing losses in the hundreds of billions. The

sudden collapse of investments deemed to be as safe as government bonds caused

hysteria in financial markets, with banks no longer lending out money in fear that

they might not be paid back. This credit crunch ground the global economy to a halt,

and Lehman Brothers, a bank with $639b USD in assets, had to file for bankruptcy

because it couldn’t borrow money to fund day to day operations.

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Contrarian Investing One of the drawbacks of a university education in finance is that the majority

of financial theories are taught with the underlying assumption that investors

act rationally. This leaves graduates ill equipped to operate in the real world,

where investors introduce their innately human imperfections and

irrationalities into the mix.

The legendary investor Howard Marks likens investor psychology to a

pendulum swinging along an axis. The average point in the trajectory of a

pendulum is at the middle of the axis, even though it spends very little time

there. Likewise, investor sentiment is rarely at an even balance between

greed and fear, spending more time swinging from one extreme to the other.

The S&P 500 tracks the movements of the 500 largest companies in America,

and since 1929 has averaged just over 6% p.a. after inflation. Remarkably,

only 9 of those 89 years experienced returns within 2% of the historical

average. Wild fluctuations of the pendulum are the norm!

There are many reasons for this impressive volatility, however an

underappreciated factor is investor psychology. When times are good, the

pendulum of investor psychology swings towards greed, credulousness and

risk-tolerance. Investors assume that the good times will continue on forever,

because “this time it’s different”, and pay prices that assume blue skies

forever because they can’t remember the last time it was a rainy day.

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Inevitably, storm clouds appear, and the pendulum swings towards fear,

incredulity and risk-aversion. Investors rush for the exit, caring more about

cutting their losses than taking advantage of the hysteria of the market.

Investors sell at prices that assume that we’ll never see a blue sky again, and

previously overpriced investments become bargains.

Warren Buffett once wrote that investors should be fearful when other are

greedy and greedy when others are fearful. This does not come naturally to

us, as our evolutionary psychology was formed in an environment where

conformity and unity was necessary for survival, making contrarian behaviour

uncomfortable. However, contrarian investing is the best way to buy low and

sell high, whilst following the herd is an express lane to buying high and

selling low.

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The Risk Premium Although investing isn’t governed by natural laws like we see in the natural

sciences, one of the unavoidable aspects of investing is that returns are

proportionate to risk. Stocks, bonds, bitcoin and everything else in between

have their unique risks and rewards, which contributes to the divergence in

their returns and volatility.

A business professor once quoted that “risk means more things can happen

than will happen”. The higher the chance of a negative development, the

higher return investors will demand to compensate them for that risk, which

is known as a “risk premium”. For example, governments and corporations

both issue bonds (debt) to finance their operations, however, government

bonds are viewed as safer than corporate bonds. This is because the sales

revenue of corporations is less stable than the tax revenue of governments,

meaning an investor in corporate bonds should demand higher returns than as

they run a higher risk of not being repaid.

The chart below is a simple example of the relationship between return and

risk. The curved lines represent the probability of a return, the most likely

scenario occurs where the curve is widest, whilst the least likely scenarios

occur when the curve is narrow. This is why it’s misguided to say “shares

return 8% per year”, as a range of other outcomes have a high probability of

occurring.

74

Investment markets are not governed by concrete laws like the natural

sciences because they consist of human beings, who are flawed decision

makers. When times are good, investors get complacent about risk and don’t

demand a large risk premium, making investments expensive. When times

are bad, investors become too risk-averse and demand too high a risk

premium, making investments cheap. We currently don’t view shares as

offering a sufficient risk premium, and have positioned our client portfolios

accordingly.

75

The Wealth Effect Much to this (Ed – a millennial) writer’s lament, the recent weakness in

property markets has not tapered the general public’s obsession with

property prices, with debates about how high prices will rise being

substituted for debates on how far prices will fall. Some have been

particularly creative in their analysis of market sentiment, claiming that FOMO

(fear of missing out) has been replaced by FONGO (fear of not getting out) or

even FOOP (fear of overpaying). A commonly overlooked factor in these

discussions is how slumping property prices will affect economic activity in

Australia, which relates to an economic theory known as the wealth effect.

Put simply, the wealth effect is how an individual’s perception of their

personal wealth affects their spending habits. When an investor’s portfolio

rises in value, they feel richer, making it easier to justify spending more

money and saving less. Conversely, when an investor’s portfolio is declining,

they feel poorer, and are more inclined to spend money conservatively and

increase their savings. More than half of Australian household wealth is tied

up in property, meaning that shifts in the value of Australian property can

have a large impact on the spending habits of consumers.

Spending is the lifeblood of the economy, since every dollar spent by a

consumer is a dollar of revenue for a business. A 20% decline in property

prices would significantly reduce the net worth of hundreds of thousands of

Australian households, and could put many homeowners in mortgage

distress. The response of many households would be to tighten their belts

and reduce their spending on non-essential items (buying a new car, a new

wardrobe, etc), reducing the earnings of thousands of businesses.

Many prospective homeowners and investors are hoping for a sharp

correction in property prices, hoping that they will be able to buy on the

cheap. A correction of this magnitude would significantly curtail economic

activity, likely plunging the economy into recession and making it extremely

difficult for buyers to receive the bank loan required to purchase the cheap

property. Be careful what you wish for!

76

Passive vs Active Investing If you were offered an Australian equities strategy that was by far the

cheapest on the market and had outperformed 80% of all other strategies

over the last 15 years, would you invest? If so, look no further than your run

of the mill index fund!

One of the largest developments in the investment industry is the trillions of

dollars that have flowed from active strategies (where portfolio managers are

paid to try and outperform the market) to passive strategies (where portfolios

are constructed to mirror the performance of the market). Active managers

throughout the world struggle to outperform their benchmark consistently,

and that’s before they charge their fees!

Source: S&P

The growing acceptance that the majority of strategies will underperform the

market, plus the availability of index funds that charge next to nothing (and

sometimes nothing!), is mostly responsible for the monstrous amount of

money flowing into low cost passive funds. Some investors, however,

hesitate to invest in index funds because they are not content with “ordinary”

returns, preferring to try their luck picking a strategy that will beat the market.

The flaw in this logic is that a significant majority of investors fail to beat the

market, meaning that receiving market returns puts you well ahead of most

people!

77

Although outperforming the market over time is a difficult task, it is not

impossible. There are strategies that have proven to outperform in the long

run, however periods of short term underperformance are inevitable. US

researchers found that over 10 years, 90% of the top performing strategies

had a 3-year period where they delivered sub-par returns. In a previous

Finance 101, we wrote that even a clairvoyant would underperform the

market at times, highlighting the importance of investing for the long term.

If you are going to invest in an active manager, you must do extensive

research to be confident that the strategy is likely to outperform the market

after fees in the long-run. To say that the task of outperforming the market is

difficult is a wild understatement. In the words of American financier Bernard

Baruch “If you are ready to give up everything else and study the whole

history and background of the market and all principal companies whose

stocks are on the board as carefully as a medical student studies anatomy—if

you can do all that and in addition you have the cool nerves of a gambler, the

sixth sense of a clairvoyant and the courage of a lion, you have a ghost of a

chance”.

78

Moral Hazards An article in The Economist highlighted how individuals and organisations are

more likely to engage in reckless behaviour if they are protected from the

consequences of that behaviour. This phenomenon is known as ‘moral

hazard’, and was prevalent during and in the aftermath of the Global Financial

Crisis.

The financial crisis was triggered by a collapse of the US sub-prime mortgage

market. Low interest rates had investors searching for yield, and this demand

was met with mortgage-backed securities (securities that have claim to the

monthly payments of thousands of residential mortgages). A mortgage broker

would arrange a loan on behalf of a bank, which would then on-sell thousands

of loans to an investment bank, which would in turn create financial securities

to sell to investors. Before long, lending standards had been considerably

loosened, since nobody had any incentive to ensure that the debtor could

repay their loan. The moment a sub-prime mortgage was sold to another

investor, it was their problem. Inevitably, borrowers defaulted on their loans

and the mortgage-backed securities plummeted in value (captured brilliantly in

the film ‘The Big Short’).

Researchers have studied the fares charged during taxi trips. Unsurprisingly,

they discovered that tourists were 17% more likely to be overcharged for

their trip; but they also found women were charged more than men, and

business people more than locals. The authors of the paper put this down to

women being less likely to complain and the moral hazard of business

expenses!

79

Bond Yields One of the key principles of finance is the inverse relationship between bond

yields and bond prices. To the layman investor, it may seem counterintuitive

that rising bond yields are bad for bondholders.

Imagine that there is an investment that is guaranteed

to pay $100 in a year’s time. If you paid $98 for that

investment you would have a yield of 2%. Since the

future return of the investment is fixed at $100, if the

yield of that investment rises to 5%, the market price of

that investment must have declined.

This is the basic intuition behind the inverse relationship of bond yields and

bond prices: since the cash flows of the bond are fixed, the only way they can

offer a higher return is if their price lowers. This relationship underpins how

central banks use monetary policy to influence economic and market

conditions. If a central bank wants higher consumption and borrowing, it can

buy bonds in the open market to lower yields and interest rates. If a central

bank wants to slow down an overheating economy, it can sell bonds in the

open market to raise yields and interest rates.

Our portfolios have been positioned for rising rates (by being overweight

floating rate bonds) since early 2017. Bond yields are rising. And bond prices

are falling.

Price Yield

$90 11%

$95 5%

$98 2%

$99 1%

$100 0%

$101 -1%

80

The Time Value of Money If you were offered an investment that guaranteed a payment of $100 in 10

years, what is the most you would pay for it today? According to classical

financial theory, it would be just over $75. This is the amount you’d have to

invest in a 10yr government bond today to end up with $100 in 10 years’

time. There is no reason why you’d pay more than $75 if you could get the

same outcome by investing in an asset almost guaranteed to provide the

same cash flow.

Investing boils down to estimating the cash flows an asset will deliver in the

future (e.g. the proceeds of a contract), and trying to calculate what those

future cash flows are worth today, which is known as cash flow discounting.

This is a key reason why financial markets sold off in recent weeks. Rising

bond yields due to inflation fears result in a higher discount rate, which means

that the future cash flows of companies are worth less. In September, US

10yr government bond yields were just over 2%. They have since rocketed

up to 2.90%, which as the table below illustrates, has a profound impact on

what future cash flows are worth today.

Discount Rate $100 in 1 yr $100 in 5 yrs $100 in 10 yrs

0% $100 $100 $100

0.5% $99.5 $97.5 $95.1

1% $99.0 $95.1 $90.5

2% $98.0 $90.6 $82.0

3% $97.1 $86.3 $74.4

4% $96.2 $82.2 $67.6

81

The Carry Trade The carry trade involves borrowing money in a country with a low interest rate

(cheap debt) and investing in a term deposit in a country with a higher interest

rate. If exchange rates do not change, the investor will earn the difference

between the two interest rates whilst investing in a risk free asset.

Historically, this has been a boon for the Australian dollar, as our interest rates

have tended to be among the highest in the developed world thanks to our

relatively high inflation rate. This is no longer the case, as Australia is lagging

most major economies in its inflation expectations and schedule to raise

interest rates. This means that investors will soon be selling the AUD to buy

other currencies, which is a healthy development as a lower AUD will boost

exports and give the RBA more scope to raise rates.

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

-5%

+0%

+5%

+10%

+15%

+20%

+25%

+30%

19

80

198

3

19

86

19

89

19

92

19

95

19

98

20

01

200

4

20

07

20

10

20

13

20

16

USD / AUD

Aust-US Interest Rate Differentials & Aust Dollar

OWEN,

2003-7 China +

credit boom

2008 GFC

2011 mining peak

2001-2 tech

wreck

Dec 1983 float

2014-5 commodcollapse 2016-7

Chinarebound

1986 current

a/c crisis

1990-1 recession late 1990s

dot com boom

ForecastingFALL in

AUDAust-US Interest rate differential

Forecast fair LEVEL of AUD

USD / AUD

Red = Forecast 1y CHANGE in AUD

82

The Laffer Curve Many market oriented economists argue that lower tax rates increase tax revenue,

but how does that work?

Income tax revenue is a function of two variables: economic gains (salary,

investment income, capital gains, etc) and the tax rate that is applied to those gains.

A common metaphor is that economic gains are a pie, the tax rate is the % of the

pie taken, and tax revenue is the size of the slice of pie taken.

Using this metaphor, Malcolm Turnbull is arguing that a lower tax rate will result in

more investment and economic growth, which will result in a larger pie to take taxes

from. It can be better to tax a smaller slice from a larger pie than a larger slice from a

smaller pie. In economics this is known as the Laffer Curve, named after American

supply side economist Arthur Laffer.

So should Australia lower its company tax rate? It depends. On the one hand, a

lower tax rate would spur business investment and make Australia a more attractive

destination for international corporations. For example, global behemoths such as

Apple have established business operations in Ireland thanks to its juicy 12.5%

corporate tax rate. On the other hand, Australia is yet to meaningfully address its

budget issues, and it can take a number of years before tax revenues under the

lower tax rate reach their previous peaks. Something about rocks and hard places.

83

Protectionism The resurgence of populist political parties has revived an economic myth long

thought to be dead – being that it is in a country’s best interest to protect

established industries from cheap international competition with a tariff on

imports.

When considering the benefits of protectionism, or any economic policy, keep a

quote from the economic Henry Hazlitt in mind: “The art of economics consists

in looking not merely at the immediate but at the longer effects of any act or

policy; it consists in tracing the consequences of that policy not merely for one

group but for all groups”.

There is no doubt that these tariffs will benefit American steel and aluminium

producers, and there will likely be more jobs in these industries, but the tariffs

will also affect other industries. Any industry that uses steel or aluminium as an

input (construction, transport, energy, consumer packaging, appliances, etc) will

now have their costs of production increased, which will reduce growth and

profitability. These companies will likely cut jobs and increase their prices to

maintain their profit margin, meaning their customers and former employees will

have less money to spend on the products of other industries.

The reason why tariffs persist, according to Hazlitt, is that the benefits of tariffs

to the protected industry are clearly visible, whilst it is much harder to observe

the costs of the policy because it they are thinly spread out over many

consumers and producers. In essence, tariffs support industries that can’t stand

on their own two feet at the expense of industries that can, which destroys

economic value.

84

Job Creation Programs One of the most commonly used arguments in support of expensive

government infrastructure projects (new stadiums, bridges, etc) is that they

will create jobs. The next time you hear this line of thought, remember this

anecdote featuring Milton Friedman. Friedman was travelling in China in the

1960’s and was taken to a worksite where a new canal was being built. Much

to his surprise, instead of modern equipment such as tractors and

earthmovers, the workers were using shovels. When Friedman asked why

there were no heavy machinery, a government official replied that the canal

was a jobs program, to which Friedman replied “I thought you were trying to

build a canal. If it’s jobs you want, give these workers spoons, not shovels”.

This lesson ties back to last week’s lesson about considering the effects of

economic policies on all groups rather than a specific interest group. It is easy

to see the benefits of these infrastructure projects in the form of employed

workers and a completed road or stadium, what we don’t see are the jobs

that weren’t created because taxpayers have less money to spend on other

industries.

Like any other government policy, the benefits of infrastructure spending

should always be weighed against the costs. The purpose of infrastructure is

to facilitate productivity and economic growth, and any project that costs

more than the economic benefits it provides should not be pursued

regardless of how many jobs it creates.

85

Trade Wars Although Trump’s current trade war is garnering well deserved criticism, he

draws from a rich history of American leaders enacting misguided

protectionist policies for the supposed benefit of the domestic populace.

In 1930 as global trade was coming to a standstill thanks to the Great

Depression, the US government passed the Smoot-Hawley Tariff Act in order

to protect American industries. This prompted retaliatory tariffs from other

nations, which harmed American exporters as their products became more

expensive to international consumers and slowed down economic activity

even further. Economists of all persuasions agree that Smoot-Hawley

exacerbated the Great Depression. These trade wars laid the path for what

may have been the most misguided policy of the Great Depression.

In 1933, a time of mass starvation and economic misery, the US government

tried to increase agricultural prices by paying farmers to reduce their crop

production. Prices had fallen because American farmers no longer had a

robust international market to export to. Farmers got paid not to work, and

already hungry Americans had their food bills increased.

Advocates for protectionism usually promote defending exports at the

expense of imports. What they often fail to understand is that demand for

exported products relies on the strength of foreign economies, which is

compromised when tariffs make imports more expensive.

86

Inflation Inflation is one of the most important, and

most misunderstood, variables in economics

and finance. Inflation refers to a general

increase in the prices of goods and services,

which is typically a by-product of economic

growth. As the wealth of consumers

increases, they can afford to spend more on

goods and services, which raises their prices

as demand outpaces supply. As evidenced by

the adjacent photo, the cost of living has risen

significantly in the last 60 years, but so have

wages.

Central banks can be slow to raise interest

rates because a key driver of consumer

demand is their ability to service debt. When

people have to pay more interest on their

credit card and mortgage, they have less to spend on groceries, clothing,

movies, etc. Because Australian wage growth is stubbornly low, the RBA has

little need to increase interest rates as it would slow down the economy,

lowering wages even further.

In recent years central banks around the world have tried to increase inflation

by lowering interest rates to encourage consumers to borrow and spend

more money. However, this current low inflationary environment is mainly

due to supply side factors. Examples of this are the technology revolution, the

rise of online shopping, globalisation and the decline in union membership.

Inflation is the result of both supply and demand, and when central banks try

to solve a supply phenomenon with demand, they can create unintended

consequences (look no further than Sydney’s wildly overpriced housing

market for proof of this).

87

Making Money Out of Thin Air When they’re not fronting the Royal Commission, banks play a critical role in

the functioning of a healthy economy. Most people cannot afford to support

their lifestyle (home, cars, kids, etc) solely on their current income. Banks

allow us to use our future income (in the form of interest payments) to

finance current expenses (in the form of a loan). This allows us to start

businesses, buy houses, go to university, and do a whole range of other

essential economic activities that would be almost impossible on our current

incomes.

An interesting phenomenon is that when a bank loans out money, it can start

a chain reaction that allows other banks to loan out money which can in

essence create money out of thin air. Take the example below, where banks

are required to keep 20% of their deposits but are free to loan out the

remaining 80%.

At the end of this process, there will be $500 worth of deposits in the banks

even though the initial deposit was only $100. This is known as the money

multiplier effect. This system works fantastically as long as everyone can pay

off their loans and the depositors don’t try to withdraw their money all at

once. However this is not always the case, and when banks begin to lose

money on bad loans, depositors start to question whether the bank will be

able give them their deposit back. When all the depositors try to withdraw

their money, a bank run occurs and the bank is often unable to pay all

depositors and risks default.

In the words of Ed Bailey in It’s a Wonderful Life - “The money’s not here.

Your money’s in Joe’s house… right next to yours. And in the Kennedy

house, and Mrs Macklin’s house, and a hundred others”.

88

P/E Ratios One of the most quoted, and misunderstood, ratios used by investors to

gauge the value of an investment is the Price/Earnings ratio (P/E ratio). The

ratio is the price paid for a share divided by the earnings each share

generates. A high PE ratio for a company indicates that the market believes it

has strong prospects of future earnings growth. As the examples below

suggest, a higher P/E ratio means you’re paying a higher price for the same

amount of earnings or getting lower earnings for the same price.

So why would an investor pay $100 for Stock A when it is earning as much as

Stock C? Perhaps Stock A is a market leading nanotechnology firm whilst

Stock C is a domestic car manufacturer. Investors seek growth potential in

their investments, so they are willing to pay a premium for companies in high

growth industries and discount companies in declining industries.

Journalists, academics and pundits alike often quote high P/E ratios to

support their claim that a particular investment is overpriced, advising to avoid

the investment until it has more reasonable fundamentals. This reasoning is

flawed because the current price may be expensive relative to current

earnings but not to higher future earnings. Furthermore, investments often

remain overpriced for months or even years, meaning an investor that sells

out when their investments appear expensive can miss out on fantastic

returns (e.g. a Pizza company on the ASX was at a P/E ratio over 50 for many

years). The old investment adage is “buy low, sell high”, not “buy low, sell

reasonable”.

Shareprice Earnings per share P/E ratio Shareprice Earnings per share P/E ratio

Stock A $100 $5 20 Stock A $20 $1 20

Stock B $50 $5 10 Stock B $20 $2 10

Stock C $20 $5 4 Stock C $20 $5 4

89

Tackling Automation With automation threatening almost 60% of the world’s jobs, policymakers

and pundits alike are trying to tackle the question of what reforms need to be

made to prevent the welfare system being overwhelmed by a wave of

displaced workers. The most common solution you’ll hear is the Universal

Basic Income (UBI), whereby the government sends every citizen a cheque to

cover basic living expenses. The concept of a UBI is starting to gain traction

globally, with governments in Finland, Kenya, Canada and Scotland trialling

the system.

Although this seems like a quick fix to the problem of mass unemployment,

detractors question the fairness (should millionaires receive the same subsidy

as the unemployed?) and feasibility (how can the government afford to pay

every adult a living wage?) of a UBI. A more practical alternative to the UBI is

the negative income tax, where low income individuals are given a tax refund

that diminishes as their salary increases.

The primary advantage of a negative income tax over a UBI is that the benefit

payments only go to low income individuals, which reduces the tax burden of

the program and can allow the benefits to be more generous. Furthermore,

the program incentivises work, avoiding the creation of a welfare trap where

low income individuals choose not to work because the benefits they lose are

worth more than the income they receive.

Although the robots may not be here yet, the threat of automation provides a

chance to rethink our welfare policies, which both aisles of politics agree

need reform.

Negative Income Tax

Taxable Income - Tax due + Tax Refund = Total Income

$0 $0 $20,000 $20,000 Tax Rate

$5,000 -$1,250 $17,500 $21,250

$10,000 -$2,500 $15,000 $22,500

$20,000 -$5,000 $10,000 $25,000

$30,000 -$7,500 $5,000 $27,500

$40,000 -$10,000 $0 $30,000

$200,000 -$50,000 $0 $150,000

$1,000,000 -$250,000 $0 $750,000

Half of the difference

between $40,000 and

taxable income

25%

Tax Refund

90

Home is Where the Heartbreak is When it comes to patriotic investors, few countries can hold a candle to

Australia. Despite only accounting for 2.4% of the global sharemarket, two

thirds of the average Australian investor’s share portfolio is allocated to

domestic companies. This is a result of the home bias, where investors tend

to overinvest in local companies because

they are more familiar with them (it’s

easier to convince an Australian to invest

in an Australian bank than an American

bank, even if the America bank is a better

investment opportunity).

Investing solely in domestic equities

results in an undiversified portfolio,

which harms investor returns in two

ways. Firstly, returns tend to become

concentrated within a small number of

sectors. Two thirds of the Australian

market is either banks or miners,

meaning that investors have to tie their life

savings with the future of those industries (miners have no pricing power and

the big banks are scandal ridden dinosaurs). Meanwhile, the largest sector in

the MSCI World index is technology, which has a much brighter future (and

present) than banks and miners.

The other downside of the home bias is that it concentrates risk.

Overinvesting in domestic shares means that investors are overexposed to

any risks specific to the Australian economy (e.g. a fall in commodities prices

or a housing downturn). Holding a diversified portfolio of global shares allows

investors to sleep at night knowing that a Royal Commission or drop in

Chinese demand for iron ore isn’t going to wipe 10% off your portfolio

tomorrow.

Ultimately, when you buy a share you become an owner of a business. If you

had the opportunity to own any business in the world, would you restrict your

choices to Australian companies only? Think global!

Source: Vanguard Investments

91

How Regulations Can Stifle Business In light of the findings of the Royal Commission, many are calling out for

banks to be more tightly regulated. But before we cry havoc and let slip the

dogs of more, we should take a deeper look at the effect of regulations.

Although most regulations are created with good intentions, they often favour

larger businesses by stifling competition. Most companies generally prefer to

have fewer competitors, as it means they can increase prices without

worrying about customers taking their business elsewhere. Regulations can

reduce competition by creating an artificial barrier to entry, whereby the cost

of compliance discourages the creation of new businesses. According to

Liberal Senator James Paterson “In NSW, for example, it takes 48 separate

forms and 72 licences just to open a restaurant. Becoming a hairdresser takes

847 hours of study, and can cost up to $9970”. Incumbents in an industry will

often call for tighter regulation in the name of maintaining quality standards,

which conveniently also makes it more burdensome for new competitors to

enter the market.

One of the many reasons why Australia does not have a dynamic economy is

due to the burden of government regulation, where the World Economic

Forum ranks us 80th in the world behind the likes of Trinidad and Tobago,

Vietnam and Kyrgyzstan. Unfortunately, the cost of these regulations isn’t

obvious, as we don’t see the businesses and jobs that would’ve been created

in absence of these regulations. According to some estimates, red tape costs

the economy more than $176b each year. For comparison, the total value of

the iron ore, coal and natural gas exported from Australia in 2017 was $146b.

Of course, there are instances, such as the recent Royal Commission, where

it is obvious that some regulation of industry is required. However, as

commissioner Kenneth Hayne details below, increasing the complexity of

regulation does not make it more effective, and more often than not highly

complex regulations disfavour smaller businesses who can’t afford to hire a

team of lawyers to ensure compliance.

92

Negative Gearing At its core, negative gearing entails deliberately losing money on an

investment property to reduce your taxable income. A property investor can

claim a number of related expenses against their taxable income, ranging

from interest on mortgage repayments to cleaning expenses to pest control.

If these expenses are higher than the rent received from the property, the

investor can claim a loss against their taxable income and reduce their tax bill.

The appeal of negative gearing is that money that would have been spent on

tax is spent on the maintenance and development of an investment property.

An investor negatively gearing a property is making a bet that they will be able

to sell their property for a profit that exceeds the losses they’ve incurred on

the property (after taking into consideration their reduced tax bill). This

strategy worked wonders for investors who bought in Sydney and Melbourne

in 2011, however as property prices weaken, it’s unclear whether investors

who bought later in the cycle will come out in the black.

Negative gearing is particularly attractive for wealthier investors with a higher

tax rate, as they avoid paying more tax than an equivalent investor with a

lower tax rate would.

The proposed Labor policy is that future property investors would only be

allowed to negatively gear newly constructed houses, with investors who are

currently negatively gearing allowed to continue doing so. The intention is that

future property investors will be forced to develop new homes rather than

buying existing homes and pricing out buyers who want to reside in the

property.

93

Monetary Policy Most countries have a central bank (ours is called the Reserve Bank of

Australia), which uses interest rates and other mechanisms to determine how

much money is in the financial system. Monetary policy relates to the

positions of a central bank, and has a range of implications for investors.

Monetary policy can be stimulatory (accelerates economic growth),

contractionary (decelerates economic growth) or neutral (neither stimulates

nor contracts economic growth). When a central bank lowers interest rates,

borrowing money becomes cheaper and spending tends to increase. When a

central bank raises interest rates, spending tends to decrease as borrowers

have to pay more interest on their debt. In theory, a central bank can smooth

out the economic cycle by providing stimulus during downturns and pulling in

the reins when the economy is booming.

Unfortunately, economic theories usually don’t pan out in the real world.

Many argue that central banks have made the economic cycle worse. For

example, the boom in the American residential property market in the early

2000’s, which sowed the seeds for the Global Financial Crisis, was in large

part thanks to the Americas’ central bank (the Federal Reserve) keeping

interest rates too low in response to the bursting of the dot-com bubble and

9/11. Likewise, the enormous surge in Australian property prices is mostly

thanks to the Reserve Bank of Australia keeping interest rates at historic

lows, and we will see whether the current decline in prices will cause a

recession.

For investors in shares and bonds, generally speaking lower interest rates are

good for short term performance while higher interest rates are bad for short

term performance. We’ll save the story of how interest rates affect long term

returns for another day!

94

The Yield Curve Bond investors receive differing yields depending on the maturity of their

investment. By plotting these yields and maturities on a graph, investors can

try to make inferences on the market’s expectations for future economic

growth. In most instances, investors in long term bonds will receive a higher

return than investors in short term bonds as they are exposed to higher risk.

Longer term bonds are more sensitive to changes to interest rates, inflation &

creditworthiness, and there is an opportunity cost in investing in bonds rather

than stocks. When the yield curve slopes upwards (longer-dated bonds yield

more than short-dated bonds), the market typically expects economic growth

and inflation.

But what if the curve inverts? This is where yields on longer dated bonds fall

below yields on short term bonds. In these instances, it implies that the

market is pessimistic about economic growth. Every US recession since 1945

has been preceded by an inversion of the yield curve, which means investors

place great significance on it. This week markets sold off heavily after the

yield curve “inverted”. However, when we actually look at the yield curve, we

can see that it is still sloping upwards.

95

For those wondering what a meaningfully inverted yield curve looks like,

here’s a comparison of the yield curves of US bonds in 2005 and 2006.

But what if the yield curve actually inverts? Would that mean that a recession

is on the horizon? Not necessarily. Unlike the natural sciences, there are no

universal laws and principles that can be applied to investing. In the words of

the Nobel prize winning American economist Paul Samuelson “the stock

market has predicted nine of the past five recessions”.

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Knowing What You Control In an often chaotic world, most of us seek to have some semblance of control

over our future. When it comes to their life savings, investors choose to

obsess about factors of which they have little control (for example, returns)

instead of those over which they have real control (e.g. risk, how much they

invest, and the duration of their investment).

The future value of an investment is the initial investment multiplied by its

return compounded over time. Let’s take a 50 year old investor with $100,000

in their super, who wants $500,000 by the time they turn 70. There are three

ways they can achieve this goal:

1. Invest at a higher return – the investor will need to average returns of 8.4%

in order to achieve their goal

2. Invest for a longer timeframe – if the investor starts at age 45 instead of

50, they only require a 6.65% return to achieve their goal

3. Increase their investment – if the investor invests an additional $30,000,

they will only require a 6.97% return to achieve their goal

It is natural for investors to focus on returns, since that’s what dominates

headlines. Unfortunately, the reality is that we can’t control the returns we

earn, only the risks that we expose ourselves to (asset allocation). Although

it’s more exciting to fasten your seatbelts and pursue high returns, a

combination of prudent asset allocation, wise saving habits and starting young

are much more likely to get you there.

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Economic Fairy Tales

This week Bill Shorten declared that the upcoming federal election was “a

referendum on wages”, promising to raise the minimum wage to a “living

wage”. Shorten claims that by raising the minimum wage, we will be preparing

the workforce for artificial intelligence, automation, the ageing population and

even climate change. We can all agree that it’s not desirable for full time

workers to be living in poverty, but what’s the best way to solve this issue?

The price of labour (i.e. wages) is a result of supply and demand. Wages have

been stagnant in Australia for several reasons, but a major factor is that

Australian workers have seen minimal increases in their productivity (lower

demand), whilst globalisation has resulted in higher competition from foreign

workers (higher supply). Artificially making the cost of Australian labour more

expensive through a higher minimum wage will only accelerate the transfer of

low skill jobs out of Australia to countries with lower wages.

So how do we make wages higher in Australia? By producing workers with

skills that are in demand. The companies in Silicon Valley don’t pay freshly

graduated software engineers $200k out of the kindness of their hearts, but

because software engineering is a skill in high demand but low supply. The

best way to raise wages would be to reform the education system. More

funding isn’t required – $47b was spent by the Commonwealth and state

governments on primary and secondary education in 2017, amounting

to $12,300 per student. What’s required is a reform in curriculum, with a focus

on providing students with employable skills and preparing them for ongoing

education and training.

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Quantitative Easing So what is this Quantitative Easing señor Trump is calling for? To summarise

a previous Finance 101 on Monetary Policy, central banks attempt to steer

the economy using interest rates, raising rates when the economy is running

hot and lowering rates when the economy needs a boost. But what can a

central bank do after it has lowered interest rates to 0%? Enter the largest

monetary policy experiment in history – Quantitative Easing (QE).

Put simply, QE involves creating money out of thin air by having a central

bank purchase financial assets. The idea is that by injecting cash into the

financial markets, spending and lending will increase, which will kickstart the

economy and create jobs. The USA’s central bank, the Federal Reserve,

bought around $4t USD of financial assets (not a typo, they bought four trillion

dollars of financial assets) from 2008-2014, meanwhile the European Central

Bank purchased around €2.6t of financial assets from 2015-2018.

So how did the largest monetary policy experiment in history pan out? Much

to the bewilderment of the world’s top economists, global economic growth

has been mostly anaemic since 2009, particularly in the economic zones that

have had the largest QE programs (USA, Europe, Japan, etc). Looking back on

its track record, it appears that QE is simply trickle-down economics on

steroids – create trillions of dollars out of thin air, make rich people richer by

purchasing financial assets off them, and hope that some of that money

makes its way to the real economy.

No wonder Trump is calling for more QE - it creates more of the wealth

inequality that prompted his base to vote for him!

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Lying With Statistics There’s an old saying “There are three kinds of lies: lies, damned lies, and

statistics”. Whilst it’s true that numbers don’t lie, they can be misrepresented

in a myriad of ways to suit any agenda.

The most pervasive form of statistical deception is known colloquially as chart

crime, whereby charts are adjusted to support the author’s agenda. The

charts below show the exact same data, however the Y axis has been

manipulated to downplay or emphasise weakness in the AUD since last year.

Is it more dangerous to drive in NSW or the Northern Territory? The data can

be moulded to argue whichever side you’d like to take!

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Was Lyndon B Johnson’s War on Poverty a success? The Democrats would

argue that the poverty rate lowered 5% in the 5 years after his policies were

legislated, but Republicans could argue that poverty was already trending

lower in the years priors

Although it is impossible to avoid chart crime, the easiest way to prevent

falling victim to it is to ask yourself whether the author has an agenda.

Politicians want your votes, stockbrokers want you to make trades, and

economists want you to think their opinions are relevant. Keep this in mind

and you shan’t be fooled!

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The Disposition Effect A curious observation with many retail investors is that they tend to favour

recent winners and avoid recent losers when buying investments, yet they

tend to sell winners and hold losers when selling investments. This is known

as the disposition effect, which results in investors holding on to

underperforming investments in the hopes they’ll “come good” rather than

cutting their losses.

The reasoning behind this phenomenon is believed to a form of loss aversion,

which is an innate drive that makes us feel losses more than equivalent gains

(most people will be more annoyed losing $100 than they would be pleased

finding $100). If your run-of-the-mill investor has to choose between selling a

stock that has gone up 20% or a stock that has gone down 20%, they’ll rarely

choose the latter option since that would be a guaranteed loss. Our monkey

brains tell us that it is better to risk further losses and have the remote

chance of a rebound than to guarantee a loss!

So how do we avoid the disposition effect? One way is to imagine that an

administrative error had sold all of your holdings to cash. Would you reinvest

your cash to hold the exact same portfolio as you held before? If not, there’s

a good chance that you’re making some common behavioural finance

mistakes. The other way is to hire a quality financial adviser to take care of

your investments for you!

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Disclaimer

Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances.

This report is current when written. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not

appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.

When considering a financial product please consider the Product Disclosure Statement. Stanford Brown is a Corporate Authorised

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Representative of The Lunar Group Pty Limited. The Lunar Group and its representatives receive fees and brokerage from the provision of

financial advice or placement of financial products. The Lunar Group Pty Limited ABN 27 159 030 869 AFSL No. 470948 © 2018 Stanford

Brown.

Level 8, 15 Blue Street, North Sydney NSW 2060

PO Box 1173, North Sydney NSW 2059

Telephone: +612 9904 1555

www.stanfordbrown.com.au

Level 8, 15 Blue Street, North Sydney NSW 2060

PO Box 1173, North Sydney NSW 2059

Telephone: +612 9904 1555

www.stanfordbrown.com.au