Secrets Of Success: How to learn from behaviour theory

Reports that private investors are gearing up to make this the best ISA season for equity funds for some years is a distinctly mixed signal. It is encouraging that investors are showing an interest in the equity market once more, as equities are an essential part of any long-term portfolio, but, not for the first time, the timing of this apparent renewed interest is potentially worrying.

If the predictions turn out to be true, it will certainly be consistent with behavioural theory. This suggests that it takes two to three years before private investors are sufficiently confident about a financial market trend to start to act on it. The natural human tendency is to wait for an upward sloping line to become fairly well established before trying to jump on board. There is psychological comfort in being part of the crowd.

In this habit, our actions are reinforced by the fact that the financial-services business naturally finds it easier to sell something that has gone up say 50 per cent in the last three years than something that has fallen by 50 per cent in the same period. The only trouble with this, in real life, is that, because markets move in the way that they do, it often means that investors only start to become interested in a trend when it is close to having run its course.

Now that we are at the best part of three years into the post-bear-market recovery, it is rather late in the day to be trying to catch the idea that equities are once more looking good value. The FTSE All-Share index is up by 81 per cent over three years, and the FTSE World-ex-UK index by 73 per cent. Many brokers are still making bullish noises about the current outlook for equities, but the risk is it that the current bull-market rally cannot go on for much longer.

It is true that not many alternatives look particularly attractive, in part because of the extraordinary things that are going on in the bond markets. This week the real yield on 50-year index-linked gilts fell to its lowest level ever, at just under 0.5 per cent - a bizarre phenomenon that owes much to "enforced" buying by pension funds and life companies seeking to match their long-term liabilities. (No self-respecting professional investor would voluntarily choose to invest their own money on this basis - but it seems that it is easier to blame the regulators and accountancy standards when you are instead investing other people's savings).

The weakness of bond-yields makes buying shares easier to justify on relative grounds, and that may keep the market going a little further, but the short-term risks in moving into the equity market increase, not decrease, the longer the rally goes on. In the words of Michael Hughes, the chief investment officer at Baring Asset Management, the current climate is one of investors being "made, not paid" to take risk, an environment that has more hazards than might appear on the surface.

It is an unfortunate fact of life that private investors in aggregate have a poor record at timing their moves in and out of different sectors of the market. Here are three ways in which private investors typically go wrong:

n Long-run historical data shows that value investing (buying shares with above average yields, or below average price earning ratios) comfortably outperforms growth investing (buying shares with above average growth potential). Yet many private investors are over-represented with growth stocks in their portfolios - which in turn are most vulnerable when markets do turn down.

n Historical evidence also shows that the main course of equity returns comes from reinvesting dividends. Yet many private investors do not take much notice of dividend yields (some don't even record them) and tend to spend rather then reinvest the income. (They may have no choice of course, but the point remains valid).

n Many private investors can also be faulted for being overly concerned with maximising their returns rather than minimising their risks. When it comes to investing in shares, which are inherently riskier than other types of assets, this becomes of particular importance.

There is a nice illustration of some of these points in Jeremy Siegel's book The Future For Investors. He gives the example of two well-known companies that you could have bought in 1950. The table summarises the future growth characteristics of the two firms. To make the point more telling, Professor Siegel uses the figures that actually materialised over the subsequent 53 years - in other words, making the assumption that the 1950 investor had perfect foresight (something which is sadly not given to us in real life).

The point that Professor Siegel makes is that, while all the growth data pointed to Company A being the more attractive option, in fact Company B - despite its less impressive statistics - would have produced superior long-run returns, assuming, that is, (a key point) that the investors had reinvested their dividends. Both companies would have been excellent long-term investments, well above the average, but the comparison is nevertheless a telling one.

The reason why the second company's shares did better was that Company A's shares were already priced to reflect its superior growth prospects, as can be seen by looking at the comparable yield and price-earning ratios of shares in the two companies. In the event, while the price of Company A's shares went up more than those of Company B, this was more than compensated for by the higher income return of the latter. (For those who are interested, Company A was IBM and Company B was Exxon).

How could the higher dividend-yield make that much difference? The key mechanism is that the number of shares the 1950 investor would have ended up owning 53 years later was three times the original number in the case of Company A, but a staggering 15 times with Company B - such is the power of compounding. It is an instructive and somewhat sobering thought.