Path Sensitivity in Investing
by Alexander Beard, on Oct 20, 2015 10:27:04 AM
There are many ways of viewing the performance of investments. For example, we could compare the returns against an objective benchmark such as the FTSE 100 or the S&P 500, we could compare to a target return, or we could adjust the returns to take into account the risks taken. However, the recent volatility in stock markets has highlighted the importance of reviewing investment returns in the context of personal expectations, something that is often referred to as “path sensitivity”.
We are in danger or wandering blindly into amateur psychology here, but I will try to explain the importance of considering this path sensitivity in investing. The foundations of the ABG investment processes are built upon the concept of utility. This is a mathematical approach that is also undeniably human, because the maths summarises how people evaluate risk and reward, to choose one investment over another. The difference being that our software runs nearly 100,000 decisions simultaneously to create diversified portfolios, a process that would take a human being many months to conclude (by which time it would be too late!).
Before I get carried away explaining our processes, I would like to focus on the utility aspect. The core principle of utility is that the investment decision depends entirely upon the circumstances of the individual making the choice. I will try to demonstrate through an example. Two people have £1m to invest, both are single, they are both the same age, living in the same area, and both are entrepreneurs who have made their money by selling their company. They are both looking forward to invest the proceeds for a long and happy retirement. However, the first person created his company five years ago from nothing, whilst the second took many years to build a business that used to be worth £2m and then hit a rough patch before deciding to bail out for £1m. These two people have had very different journeys to arrive at the same point.
Where these two people go from here is, in part, determined by their past experiences. The new entrepreneur is perhaps more likely to accept risk, since they are much better off than they might have expected. The more jaded entrepreneur may be more inclined to caution having been deterred from risk due to the loss already suffered.
Apart from their differing routes to reach this point, these two people will also have a differing sensitivity to the first few steps on the next phase of the journey. The new entrepreneur is likely to be more comfortable if the first few steps on the new path falter slightly, where as any negative returns for the jaded entrepreneur are likely to cause alarm. They each have a very different path sensitivity to the early stages of their new investment, but the sensitivity gradually turns into comfort as they get further away from the departure point. As the years go by and as the long term growth in assets takes hold – which is the most likely outcome over a 5-10 year period – they will both become more comfortable.
But when evaluating the performance of investments, whilst there are many objective measures that can be used, the subjective view of the investors themselves is perhaps the most important. The early period of heightened path sensitivity needs forward looking perspective to persevere and improve the chances of success. This is where the value of advice can bring long term benefits, to provide the reassurance of a longer term perspective even if the first few steps are a bit wobbly.
Investment Director and Partner