Overcoming the crisis by analysing behaviour

Christophe Machu, Director Europe Diversified Management at M&G.

How can you overcome the return of inflation? And where should you invest to do so? All investors had to ask themselves these questions when prices went up ever faster from 2021. At that time, the myth of the perfect portfolio was influential: you had to have a mix of gold, property, indexed bonds and shares to weather the crisis. You were told to simply look back at history and the precedent of the 1970s. But in light of the past year, we can see that this silver bullet has not lived up to expectations.

The year 2022 showed that there is no one golden rule of investment for a given context. Everything depends on the additional risks, the valuations, the expectations, the behaviour, and the precise nature of the inflation concerned and its effects.

Analysing each situation

Our flexible management team has been able to offer added value for over thirty years by analysing each situation. At the end of the 1990s, we developed our management philosophy based on behavioural finance. It consists of analysing investors behaviour and identifying their potential bias to make use of them for all asset classes through a dynamic, tactical approach.

We cannot gaze into a crystal ball to see the future, so it is hard to do better than the market in foreseeing changes in the economy, statistics and business profits. But our approach is more reactive than anticipatory. In volatile periods, we try to distinguish fundamentals from behaviour, and rationality from irrationality.

Detecting excessive attitudes

A market episode is simply a phase when people open buy positions or open sell positions. But is their assessment of the risk involved always well founded?

Our analytical method has helped us detect excessive attitudes.We can make use of biases – whether they are exaggerated, experience-based or anchored.

The false positive that I mention in my introduction above – an investment portfolio that we assume to be crisis-proof – illustrates these anchored biases well. From a limited sample of events as their basis, or more generally elements impairing judgements, cognitive bias can lead to speed and binary decisions.

While a "Market Episode" results in a rapid movement in prices during a period of relative stability in macroeconomic fundamentals, we also sometimes observe "Reverse Market Episodes" characterized by changes in macroeconomic fundamentals that lead to little or no reaction from asset prices. At the end of 2021, this is what we observed when rising inflation led to a very small rise in bond yields and central banks, such as the US Federal Reserve, did not plan to raise rates before 2023-2024!

Based on this observation – and even before the war in Ukraine broke out – we increased the portion of liquid assets in our portfolios, and have taken a very cautious stance on the fixed income asset class in particular. Increasing our exposure to cash in times of inflation has, first of all, earned us criticism. Yet the months that followed proved us right.

When unnerving events occur

When unnerving events hit the headlines, it is not uncommon to identify forms of exaggeration in the variation of prices or expectations. For example, in 2022, investors ended up abandoning their certainty and acknowledging the reality of inflation. But their expectations soon swung towards an overcorrection. After abandoning the anchor of zero interest rates, and after a series of poor inflation figures, these investors no longer knew which new key rate would make sense: 4%? 5%? 6? 7%? This resulted in a significant price movement on government bonds with a form of panic in September-October 2022.

At this period, we decided to be a buyer on bonds, even though we weren't sure how inflation would go.

We always stay cautious in economic forecasts, even in our own way of thinking. We consider that the market’s collective intelligence most of the time predominates over individual intelligence.

Our own biases

We are introspective. We ask ourselves whether most investors share our interpretations or fears. We try to go against what we naturally think. We make good use of our own doubts, rather than letting those doubts torment us.

Our team meetings let us express our fears, let us see their transient or structural nature, and let us see our own biases too. Does our desire to place an order come from an emotion, a perception or an action bias, like the fear of missing out? Such reflections are not straightforward. But they are rooted in a management philosophy which has been tested through many crises and market events.

The value of a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Whenever performance is mentioned, past performance is not a guide to future performance.