Why do people make irrational investment decisions? How to make sure you don't.Netwealth portfolio construction webinar series

July 12, 2016

Disclaimer

This Technical Review has been prepared and issued by netwealth Investments Limited (netwealth), ABN 85 090 569 109, AFSL 230975, ARSN 604 930 252. It contains factual information and may also contain general advice, which does not take into account your individual objectives, financial situation or needs. The information provided is not intended to be a substitute for professional financial or taxation advice and you should determine its appropriateness having regard to your particular circumstances. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), no person, including netwealth, or any other member of the netwealth group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information.

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Meet today’s speaker

Chris IniferHead of RetailAllan Gray

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IT’S DIFFICULT BEING DIFFERENTJULY 2016

66

• Who is Allan Gray• The human – one smart primate• The investor’s chief problem • How this behaviour appears in financial markets • A practical solution • Current market thoughts – where to invest?

AGENDA

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10 years of investing in Australia

Established in South Africa in 1973

Allan Gray Australia began operating in Sydney and applied for a AFSL

Allan Gray Australia received their licence and launched the Allan Gray Australia Equity Fund

Allan Gray Australia launched the Allan Gray Australia Opportunity Fund

The Orbis Group is formed in Bermuda

1973

1989

2005

2011

2006 2016

88

THE HUMAN BEING – ONE SMART PRIMATE

Source: Wikipedia and The Age, August 2010

99

The investor’s chief problem

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THE INVESTOR’S CHIEF PROBLEM

Source: Dalbar study 1990 to 2010, Behavior Gap Carl Richards

S&P 500 Average equity investor0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

20 year annualised returns

1111

WHY ARE WE THIS WAY? – SOCIAL PROOF

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WHY ARE WE THIS WAY? - AUTHORITY

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ARE YOU MCCOY OR SPOCK?

X System (McCoy)• Similarity• Familiarity• Proximity

Source: The X and C Systems, Matthew Lieberman, 2007

C System (Spock)• More logical• One step at a time

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COGNITIVE REFLECTION TEST

1. A bat and a ball cost $1.10 in total. The bat cost $1 more than the ball. How much does the ball cost?

2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?

3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Source: S.Frederick, ‘Cognitive Reflection and Decision Making’, Journal of Economic Perspectives 19 (2005): 24-42

McCoySpock1. 10 Cents 5 cents2. 100 Minutes 5 Minutes3. 24 Days 47 Days

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THIS ONE IS FOR SPOCK

17 x 2423 x 44

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• When the problem is ill structured or complicated• When information is incomplete, ambiguous and changing• When goals are not defined or change or compete with each other• When stress is high because of time or other pressures• When decisions rely on interactions with others

WHEN ARE WE MOST LIKELY TO USE X SYSTEM?

These typically apply to investment decisions…

Source: See Gary Klein: Sources of Power: How People Makes Decisions (Cambridge, MA: MIT Press, 1999)

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How this behaviour appears in financial markets

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• Overconfidence• Loss aversion• Recency bias• Confirmation bias• Self interest

INVESTORS’ BEHAVIOURAL BIASES

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• Illusion of control• Consider too small a range of outcomes• We recognise mistakes in others more readily than in

ourselves• The ‘experts’ are often more overconfident

OVERCONFIDENCE

2020

MACRO FORECASTS AND OVERCONFIDENCE

“Stock prices have reached what looks like a permanently high plateau”

“Dow 36,000” “Dow 40,000”

“Dow 100,000”

Dow Jones Industrial Index 1929 – 1955 Dow Jones Industrial Index 1996 – 2012

Source: Bloomberg, Professor Irving Fisher, Economist, October 1929. Quotes, J.Glassman, K.Hassett and C.Kadlec

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WHERE WOULD YOU INVEST?

Country Real GDP per capita growth

A 3.8

B 2.6

C 2.6

D 2.5

E 2.4

F 2.2

G 2.2

H 2.2

I 2.1

J 2.1

K 2.0

L 1.9

M 1.8

N 1.6

O 1.5

P 1.2

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IS GDP GROWTH GOOD FOR SHAREMARKETS?

Ita Bel Ger Fra Spa Ire Jap Nor Swi Den Net Fin UK Can NZ US Swe Saf Aus0

1

2

3

4

5

6

7

8

Real equity return Real GDP per capita growth

Source: Dimons, Marsh & Staunton, ‘Triumph of the Optimists’, Princetown University Press, 2002

Real Equity Returns 1900 – 2000

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LOSS AVERSION

• We feel pain of loss greater than pleasure of win• Leads to temporary paralysis and irrational behaviour

A real life study• You are given $20 to play a game with 20 rounds• At the start of each round choose whether to invest• Each round a fair coin is flipped• If heads you win $2.50. If tails you lose your $1.

‘Normal’ group ‘Fearless’ groupOverall participation: 58% 85%After losing rounds: 40% 85%

Source:B. Shiv, G. Loewenstein, A. Bechara, H. Damasio, and A. Damasio, ‘Investment Behavior and the Negative Side of Emotion’, Psychological Science 16 (2005)

The result may surprise you…

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RECENCY BIAS

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016708090

100110120130140150160170180190200

S&P/ASX 300 TRS&P/ASX Australian Fixed Interest TR AUD

Inve

stm

ent G

rowt

h

• We tend to overweight the recent past in expectations of the future

• This leads us to buy and sell at the wrong time

• There are 11 ASX listed fixed income ETFs. All launched in 2012

Source: Morningstar

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RECENCY BIAS

+7.6% p.a. -3.7% p.a. +5.8% p.a.

Returns on Australian Bonds and Cash, 1900 – 2000, after inflation

Leads to buying and selling at the wrong time

Source: Dimons, Marsh & Staunton, ‘Triumph of the Optimists’, Princetown University Press, 2002

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CONFIRMATION BIAS

• We are more receptive to information that confirms our existing beliefs

• Less receptive to information that contradicts our existing beliefs

• We don’t like to change our minds

• It’s easier that way

• It allows us not to think

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CONFIRMATION BIAS

Time

Intrinsic Value

Share Price

Valu

e

Company A• In a booming industry• ‘BUY’ recommendations from

many stock brokers• Positive media coverage• Friends have made profit and

are buying more

Company B• Industry facing cyclical downturn• ‘SELL’ recommendations from many stock

brokers• Negative media coverage• Friends lament losses and are selling out

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SELF INTEREST (CAREER RISK)

If you were a fund manager, would you prefer….

a. 80% chance of double bonus and 20% chance of getting firedb. Guaranteed average bonusLeads fundamental managers to make non-fundamental decisions (e.g. ‘this company is 10% of index – having zero exposure is too risky’)

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LEADS FUNDAMENTAL MANAGERS TO MAKE NON-FUNDAMENTAL DECISIONS

Source: Morningstar as at April 2016

CBA WBC NAB ANZ TLS BHP WOW WES CSL SUN0%1%2%3%4%5%6%7%8%9%

10%

Weight of share in SPDR S&P/ASX 200 Fund Average weight of share - 5 largest active managers (Morningstar 'Australian Equity Blend' category)

Weight of share in Allan Gray Australia Equity Fund

Wei

ght (

%)

3030

Practical Solutions

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Shut out noise

• Our McCoy System loves a good story – don’t feed it!

• The media is paid to fill pages and is best ignored

• ‘Leading experts & economists’ are also paid to supply a good story

• Don’t believe them!

• Use your C System and independent thinking instead

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BE CONTRARIAN

‘Broker slashes its BHP profit forecast 12pc’Sydney Morning HeraldApril 4, 1998

‘Fairfax shares fall as losses hit $2.7b’The AgeAugust 23, 2012

Reasons to sell?

‘BHP makes $58m profit per day’Sydney Morning HeraldFebruary 16, 2011

‘Earnings at record level’Fairfax Media Annual Report, 2000

Reasons to buy?

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BE CONTRARIAN

‘Broker slashes its BHP profit forecast 12pc’Sydney Morning HeraldApril 4, 1998

‘BHP makes record profit’Sydney Morning HeraldFebruary 16, 2011

‘Earnings at record level’Fairfax Media Annual Report, 2000

‘Fairfax shares fall as losses hit $2.7b’The Age August 23, 2012

Source: Allan Gray data base to 2013

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DISTINGUISH VALUE FROM PRICE

Value• What you get• Stable• Driven by

fundamentals

Price• What you pay• Volatile• Driven (in short

term) by ‘animal spirits’

Value – Price = Excess Return

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SEEK ALIGNMENT OF INTEREST

Strategy 1 Strategy 2 Strategy 3

Division A Fund Mgt Division

Fund Manager (Individual)

Financial Services Firm

Fund Manager (Individual) Alignment stronger

Alignment weaker

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Social proof“Expert”

opinion

Your existing opinions Be VERY careful !

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Allan Gray – Current Thoughts

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ASX 300 INDEX FUNDAMENTALS

Source: Allan Gray Data base as at June 2016

500

1000

1500

2000

3000

5000

10000

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

ASX 300 Index

10 x Earnings

10 x Dividend

Book Value

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A DIFFICULT TIME FOR VALUE INVESTORS

1995 2000 2005 2010 2015-10%

-5%

0%

5%

10%

15%

20%

25%

Ran

k co

rrela

tion

of s

tock

s

Source: MSCI data, Deutsche Bank, Allan Gray analysis as at January 2016

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Newcrest Mining 11.1%

Woodside Petroleum 8.6%

Origin Energy 7.9%

Alumina 7.8%

Metcash 5.7%

3.8%

3.2%

APN News & Media

3.3%

National Australia bank

2.7%

Southern Cross Media Group

2.4%

TOP 10 HOLDINGS AS AT 30 JUNE 2016

Company % of Allan Gray Australia Equity Fund

AusNet Services

Worley Parsons

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• Don’t listen to ‘the experts’• Recognise biases and be contrarian• Distinguish between Price and Value • Demand alignment of interest • Evaluate your own decision making honestly• Value is available……Just because it’s popular doesn’t mean it will make money!

SUMMARY

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About this presentation and the Allan Gray Australia Equity Fund and/or Allan Gray Australia Opportunity Fund (together Funds)

Objective of presentation To provide you with some key high level information about our investment philosophy and the Funds.

Please don’t take this presentation as an offer to sell or a recommendation that you should invest in the Fund. Please read the Fund’s most recent Product Disclosure Statement and Information Booklet (together PDS) before deciding to invest in the Fund. A free copy is available from www.allangray.com.au/documents/ProductDisclosureStatementAGEF.pdfwww.allangray.com.au/documents/ProductDisclosureStatementAGOF.pdf

Issuer of units in the Funds Equity Trustees Limited, AFSL No. 240975Investment Manager Allan Gray Australia Pty Ltd, AFSL No. 298487

Fund registration The Funds are managed investment schemes registered with the Australian Securities and Investments Commission. The Funds are also registered for promotion in South Africa and New Zealand.

Who can invest? The Funds are aimed at investors in Australia. The Funds do not accept US persons and are not marketed in the European Economic Area (EEA). Investors resident in the EEA can only invest in the Funds under certain circumstances and determined by, and in compliance with, applicable law.

No personal advice This presentation has been prepared for financial advisers and only provides general information. All information provided does not take into account any investors personal financial circumstances, objectives or needs. You should read Allan Gray Australia’s Financial Services Guide, which sets out the benefits we or our related entities are entitled to receive (such as fees payable to us as investment manager). The FSG is available on our website.

Investments can go up and down There are risks with any investment, including one in the Funds. Please read the risk section of the PDS for more details. Past performance is not a reliable indicator of future performance and the value of any investment in the Funds is not guaranteed.

Economic, market or stock commentary Such information is provided to indicate reasons for our investment decisions or represents our views on certain matters. It is not intended to be personal financial advice. Such commentary is not a recommendation to deal in any security or instrument.

Other Finally, please seek professional advice, if necessary. We have tried to ensure the information in this presentation is accurate in all material respects but cannot provide any guarantee that it is.

Questions & Answers