China A-share blue-chips has underperformed the market this year, whereas some hot sectors/topics have drawn most attentions from investors. Is blue-chips out of steam? Should investors go for stocks/funds that made highest YTD returns?
Every year, some equity mutual funds making great returns, such as over 100%, however, not many funds eventually can keep and accumulate the profits. A research we’ve conducted showing less than 1% of China equity mutual funds achieved 15% annual compounded returns in the past 10 years. It is so hard to profiting in long-term even for professional investors, not to mention retail investors.
This is a phenomenon often observed in the investment world: Plenty short-term winners, only a few can last.
Why it’s so difficult to accumulate profit in long-term? We try to explain it from behavioral finance perspective.
Firstly, human brains weight much more on short-term gains, and can easily omit long-term goals, which leads to wrong investment approach.
Our society has developed in fast pace, but the way our brains work is not much different to 10,000 years ago, when long-term plan is not as important as short-term survival. And now we are unconsciously applying the same rule for investment decisions.
Human brain favors instant gratifications. For example: most people would choose chocolate ice-cream over three miles run, though everybody knows running is better for health. Likewise, investors are attracted to buy hot stocks/funds that recently had good gains, hoping to see quick profits, despite the ultimate goal is accumulating wealth in much longer term.
We did a back-test that selecting stocks with highest monthly returns and turnover ratio in the past 10 years, this strategy resulted in 90% loss. Similar result also applies if only pick funds with best short-term performance. This tells us that chasing hot stocks/funds is clearly against long-term investment goals.
In terms of selecting funds, investors need to observe fund performance for at least one market cycle with bull-bear and style shifts so that they can identify if those fund managers can bring excess returns in long-term under different market conditions.
Secondly, “Seeing is believing” often become a cognitive bias when investing, which makes investors underestimate risks when they are making profits.
Every investment has potential returns and risks, the difference is the probabilities. Most people only see returns, but ignore risks which cannot be identified easily. This cognitive bias makes investors taking unnecessary risks that can only be recognized after market crash or loss incurred. This is happening every year, every day in the market.
If we deduct potential risks from potential gains for every investment, the difference would be the long-term accumulated returns. Most investors can’t accumulate profits in long-term because the potential risks are underestimated. It’s like making bets in Casino, winning two arounds doesn’t mean you can make big money in long-term.
We believe the strategy of investing in blue-chips and actively participating in IPO placement still has attractive risk-return ratio.
On one hand, the risk-return ratio of blue-chips is getting even better due to increasing biases of the majority, some valuation indicators reached record low since 2016.
On the other hand, the IPO placement has higher certainty of profiting. The STAR board has a stable pipeline for new listings with the issuing price gradually descending, making 150% day-one rise on average for new stocks.
Also, the NEEQ board selected group placement launched in June and Registration-based IPOs of ChiNext board likely to start in August. We have been undertaking research to assess those placement opportunities.
Since human brain does not evolve quick enough to accommodate the complexity of investment, it often brings cognitive bias and misjudgment during investment process. Underestimating risk when earning profits, and focusing on short-term gains rather than long-term goals are the challenges we need to overcome.
Understanding the stock market from behavioral finance perspective can help us avoid irrational decisions that prevent long-term returns. We need to find the essence of investment without dazzled by movement of share prices and shifting of sectors. I would like to recommend a must-read book for our staffs, Misbehaving by Richard Thaler, who is a Nobel Prize Laureate for Economics. Hope we all can learn and grow.