Which investment should come into play? But investment advisors and investors are better off taking out subliminal biases that creep into decision making. Image Credit: Pixabay

Our investment philosophy hinges on the art and science of human behaviour.

In practice, we try to de-bias members of our Wealth Management Investment Committee, individually and collectively. The human brain always looks for causality behind different outcomes, even when the true cause cannot be observed.

Just look at any financial report and you will find explanations for why the US dollar rose or stock markets fell. On its own, this is not necessarily a problem. However, we also have a tendency to form shortcuts in our brain that use these explanations to try predicting what will happen in the future.

This can often be detrimental to the accuracy of our forecasts. A good example is the relationship between US interest rates and the US dollar. If asked what would happen to the US dollar if the Fed were hiking interest rates, one would probably expect the US dollar’s appreciation.

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Dollar's on its way

However, the reality is that the US dollar is more likely to rise well before the Fed actually starts hiking interest rates.

This is how the market typically reacts - by anticipating the hikes.

These shortcuts are the main reason why our Investment Committee spends a lot of time trying to identify historical relationships, also called an ‘Outside View’ by Kahneman and Lovallo. Indeed, one of the personalised advisory services we offer private banking clients entails running different scenarios to give a historical statistical perspective of asset class returns under each of these scenarios.

As one would expect, these scenarios often turn out different results, thereby reinforcing the need for the forecaster to acknowledge the uncertainty in outlook, reduce the emphasis on mental shortcuts, and plan accordingly.

Modelling scenarios

This in turn encourages investors to have diversified portfolios. Some examples of the different Outside Views as they stand today are as follows:

• If the US 12-month forward price-earnings ratio is greater than 18 (currently 22), then US equities have on average delivered -7 per cent returns over the next 12 months, recording positive returns only 31 per cent of the time.

• If the US equity risk premia (US equity market earnings yield, which is inverse of the price-earnings ratio, less the US 10-year US government bond yield) starts between 3-4 per cent (currently 3.5 per cent), then US equities have on average delivered +7 per cent returns over the next 12 months, recording positive returns 84 per cent of the time.

• If the US dollar weakens 5-10 per cent over a 12-month period (our current view), asset class returns across the board are generally higher than if the US dollar strengthens. For example, our diversified global asset allocation model has historically returned 13 per cent under a weak-dollar scenario vs 2 per cent under a strong-dollar scenario. The historical probabilities of positive returns under those scenarios were 100 per cent and 64 per cent, respectively.

These are just three Outside View examples, but they give the sense of the challenge faced by investors. Today, bonds and equities are relatively expensive, yet cash is likely to lose purchasing power as inflation is expected to be above short-term interest rates.

Our view is that this, together with a weaker US dollar, is likely to result in positive equity market returns over the coming 12 months. However, as the above Outside Views illustrate, this is far from being guaranteed and, therefore, it is important not to put all your eggs in one basket.