Saturday, 4 March 2017

J-walking, and how investors' risk perceptions are irrationally distorted

I attended the University of Auckland between 2001-05. Throughout this period I had to J-walk back and forth across a busy street regularly to reach a lecture hall. I did so for years without giving it a great deal of thought or circumspection.

Then one afternoon, as I was walking out of the hall after a routine lecture and chatting nonchalantly to a friend, I was greeted by a sudden and violent screeching of tyres, following which I witnessed a hapless young student crossing the street being hit by a car, propelled onto its bonnet, and then thrown back onto the pavement like a rag-doll (fortunately the accident was not fatal). Needless to say, it was an extremely disturbing and unpleasant experience.

A funny thing happened after that incident. I was suddenly scared to cross the road. I even remember taking a longer, circuitous route to my next lecture in the days that followed, walking all the way down the street to a traffic-lighted pedestrian crossing. My caution slowly faded with the passage of time, however. I eventually began to J-walk again, although with a heightened degree of caution. And then as the months passed, my caution slowly normalized until I had come full circle.

Anyone who has ever had a car accident (as a driver) - either major or minor - will be able to empathise. After an accident, the facade of invulnerability is immediately shattered. Suddenly, every decision a driver makes seems fraught with risk. However, as time passes, a drivers' perception of the risks will slowly trend back to normal.

Interesting and irrational psychology

The psychology here is very interesting, and has - as I'll discuss - a lot of relevance to investing and financial markets. My reactions were irrational, because the truth of the matter is that the objective risk of crossing the road never changed - it was the same as it had always been. What had really changed was my awareness of the risks, and consequently how risky it felt. After witnessing someone struck down before my very eyes, the risks became not only more tangible, but more importantly, more visceral. I had perhaps under-estimated the risk of crossing the road before this experience, but immediately following this experience, I certainly began to to over-estimate the risks.

In addition, my subjective behavior changed as a result of the incident, in a cyclical pattern. I moved in a progression from relative carelessness, to extreme caution, to modest caution, to relative carelessness once again. Due to the level of care taken, the subjective risks of J-walking were actually lower after the accident, as I took much more care when crossing. But they felt higher. 

Relevance to financial markets

This sort of irrational psychology is very evident in the way financial markets respond to and price risk, and the cyclical progression from carelessness, to extreme caution, to modest caution and then back to carelessness again, that characterizes long term secular asset pricing cycles.

When times have been good for a long time, people start to forget the last 'accident' (i.e. the last market downturn) and conduct their affairs with less prudence. Figuratively, people start to 'J-walk carelessly'. It doesn't feel risky at the time, because no one has been hit by a car for a long time, but the truth is that this is exactly when the risks are the highest, because the relative lack of care taken increases the risk of an accident occurring. It is also when asset prices are the highest, and therefore offer the least reward. High risk low return.

However, after an accident occurs - e.g. a recession, housing bust, banking system collapse/recapitalisation, or share market melt-down - risks feel viscerally very high to investors. Behavior changes as a result. People - formerly J-walking with alacrity - start to J-walk with extreme trepidation, or indeed avoid J-walking all-together. In the financial world, this means avoiding equities/risk-assets entirely or having only a small allocation, and also avoiding perceived high-risk sectors, such as banks, that were hit hard in the previous down-cycle. However, this is exactly when the risk of an accident is the lowest due to widespread prudence and restraint. It is also when prospective returns are the highest, because prices are low. High return low risk.

A present day example

A present-day example is worthwhile here to drive home the point. The Australian banks trade at 2-3x book and low-to-mid-teen multiples of cyclically-elevated earnings - very full multiples for a bank. They are also also objectively risky, because their balance sheets have significant exposure to mortgage lending in a country that has been experiencing a property bubble, while on the funding side, the banks are running 120% LDRs, and so are reliant on sometimes-fickle international wholesale markets to fund their lending activities. The same can be said about the property market - objectively, house prices are extremely high at present on virtually any fundamental metric. This is the equivalent of saying that the street is as busy and accident-prone as it has ever been.

However, viscerally, the Australian banks feel relatively low risk to most investors, because for virtually 25 years straight, they have grown, remained highly profitable, and paid handsome dividends. In addition, viscerally, the housing market feels low risk to property investors and a sure upward bet, because prices have marched ever higher for 25 years alongside falling interest rates. Human being are pattern-recognition machines, and people think they detect a pattern when they cross the road every day for 25 years and nothing goes wrong. They grow more confident, and cross the street more-and-more frequently with less-and-less care, and forget that (1) disaster can strike at any time; and (2) risk is generally non-linear in nature. The result: investors are J-walking with alacrity, despite the street getting objectively more and more accident-prone.

Compare this situation to the price of many European banks - especially South and Eastern Europe and Russia - as well as the US banks until fairly recently. These banking systems and economies all went through an extremely tough period during the GFC (and Russia more recently, as it was hit by a combination of sanctions and falling oil prices). They were all hit by a proverbial bus. Indeed, many peripheral European economies experienced a veritable depression.

The banks are now objectively low risk as a result. Their loan books have been stress tested in the extreme; large swathes of bad debt has been written off; capital levels have been raised; wholesale funding has been replaced with domestic deposits; households and corporates have deleveraged; and economic activity has been rebased to more sustainable level, as prior economic imbalances have been significantly reduced or entirely eliminated. Indeed, many of these economies now have current account surpluses - even Greece (which has swung from -15% to a minor surplus). However, having so recently been hit by a bus, these countries and their banking systems still feel risky to investors on a visceral level, and so investors shy away from them. Images of people getting run-over by cars are still fresh. As a result, banks in these countries are cheap.

The same aversion to banks existed in the US for many years following the GFC as well - indeed arguably until as recently as mid-2016. Bank of America got down to as low as US$5 in 2011, or to just one third of book, when bankruptcy was already an extremely remote possibility, and when there had already been a significant change in management behavior and risk-appetite. Investors refused to J-walk for many years. These fears have slowly lifted over time, however. Investors are now J-walking again - Bank of America just hit US$25 (I've reduced my BAC exposure materially in recent months and continue to reduce it).

Indeed, the significantly lower risk embedded in banks after a downturn is particularly the case because the psychological phenomenon described affects not just investors but also corporate managements teams. The riskiest time to own a bank is when times have been good for a long time not just because valuations are high, but because bank management has likely become increasingly careless/complacent as time has gone by and has started to J-walk frantically itself. By comparison, after a bust like the GFC, extreme risk controls are usually put in place by banks. It can be hard for anyone to get a loan or mortgage for years after a significant housing and banking system collapse, as lending standards are tightened. This is exactly when banks are the lowest risk, because management behavior has changed. They stop J-walking.

The lesson

The lesson is simple. As an investor, you should start to J-walk immediately after an accident has occurred. And when everyone else is J-walking with alacrity, you should cross with extreme caution or even consider walking down the street to the light-crossing.

Of course, the problem is that this is much easier said than done for many investors, because human beings are emotional creatures rather than rational automatons. It is easy to tell someone they should eat salad instead of junk food, and jog regularly instead of slouching in front of the TV. People may even commit themselves to such a program. But emotions often result in people failing to follow through on these prior commitments, and doing things they know they shouldn't do, because they can't help it - their emotions compel them to do it. And these emotional compulsions extend to the types of investment decisions many investors make.

This is why most investors never learn from the past; bubbles and busts systematically recur; and why there will always be opportunities to profit for investors that know how to keep their emotions in check and implement a disciplined investment program. This is what Buffett means when he talks about investing 'temperament'. How smart you are is irrelevant to this temperament. It's easy to be smart enough to know you probably shouldn't order fast-food take-out for dinner, or go for that rich dessert when you're already full and are on a diet. But if you're like most people, you'll probably do it anyway at least some of the time.

Comments welcome.