It is easy to think about the merits of any asset class as based entirely on its financial return prospects, but what if an asset provides a different benefit – what if it makes us feel good? Are we then happy to accept a lower financial return? A forthcoming paper by Elroy Dimson, Kuntara Pukthuanthong and Blair Vorsatz seeks to answer this question by appraising the investment performance of collectibles such as classic cars, art, wine and stamps. They find evidence of lower financial returns for assets with a positive emotional value. This has broader implications for our investors than simply the world of violins and carpets.

The limitations around the data on collectibles means the methodology applied for the study is complex – it is not straightforward to calculate a Sharpe ratio for English 18^th century furniture – but I will describe the approach in simple terms. The researchers compared the returns of 13 collectible asset class categories over up to 110 years to a risk-appropriate portfolio of liquid securities. They were seeking to answer the question – how does the performance of collectibles compare to traditional, liquid market portfolios of equivalent risk? *

And the answer was that the collectibles underperformed by an average of 2.5% per annum. The researchers contend that while the liquid asset portfolio has only a financial return element, the collectibles have a non-financial return – what they call an ‘emotional yield’ – which is the reason for the performance gap.

What the authors define as an emotional yield is some emotional benefit that is derived from owning the asset. They define this as private enjoyment and social signalling. If I own a valuable painting, there is some utility from the fact that I enjoy looking at it, and from what other people think it says about me that I own it.

If an asset brings us some form of pleasure or enjoyment, then we require a lower financial return from holding it.

Although the methodology underpinning the paper is complex and necessarily imperfect, the idea that the emotional impact of an asset has an influence on its returns is a compelling one. How we feel has a huge impact on our decision making and judgement, but is incredibly difficult to either acknowledge or measure. It seems perfectly aligned with human behaviour – and indeed rational – that if we have two assets, one in which owning it makes us feel good and one where ownership generates no emotional benefit, we will be content with a lower financial return from the one which is more affecting.**

One unanswered question is the extent to which investors know that they are receiving a lower return. With assets such as collectibles, deriving high quality returns data is inevitably difficult, and there is no reasonable way for anyone to compare performance to a ‘risk equivalent’ portfolio of liquid assets. It would be interesting to explore whether investors would be willing to explicitly makes this type of trade-off.

The Wider Implications of Emotional Yield

While the paper focuses on the world of collectibles, the notion that the presence of an emotional yield impacts our required return has potentially broader ramifications. The authors touch upon – but do not explore in detail – the potential for the concept to be meaningful for ESG investors. If we believe our investments are doing good, that makes us feel good, and therefore we benefit from a positive emotional yield and may accept lower returns.

This seems plausible although the level of emotional yield we might derive from holding an asset, must be related to the strength of emotions elicited. For tangible assets – such as jewellery or coins – this can be incredibly strong, as we have full ownership and can hold, see and feel an object. Information about partial ownership of a company and the ESG-related activities it is undertaking is far less salient. To generate an emotional yield, investors need to be made to feel something.

We have discussed only the potential for a positive emotional yield, but what about the opposite situation? Do investors require a higher return for assets that take an emotional toll? Those that make us feel bad for owning them. As with ESG, it is fair to question the emotion that can be generated by simply owning stocks and bond which can often feel abstract. Even taking this into account, however, it would seem reasonable that we want to be compensated for holding assets that make us feel discomfort or some level of guilt. It is perhaps an idea that can be applied to value investing more generally given the negative sentiment that is likely to surround anything falling into that categorisation.***

One other important implication that the authors highlight about the impact of the existence of an emotional yield – on collectibles in particular – is the potential limitations of tokenisation. By their analysis investors owning collectibles achieve a lower return which is offset by the positive emotional impact of full ownership. If a collectible is tokenised and ownership is fractional, an investor bears the cost of the lower financial return, but without the emotional yield. I don’t get to enjoy the painting hanging on my wall, but I might well pay for it.

—

One of the most glaring omissions in all discussion on financial markets and investor behaviour is the role that emotions play. When it is discussed, it is generally focused on the negative behavioural implications of fear and greed, and how they lead to poor decisions. This new paper applies a different lens and makes a strong case that how an asset makes us feel when we own it might just impact the returns we are happy to make. 

—

* There is a lot of complexity in the methodology which might not make for enjoyable reading in a 1000-word blog post. Please do read the full paper for details.

** When I refer to emotion here, I am talking specially about how holding the asset makes us feel, not the emotions that price fluctuations might provoke. 

*** In a way, we can think of the higher returns required for owning more volatile assets being a form of emotional yield. We want recompense for the stress and anxiety of ownership.

—

---

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Asking questions about what an investor believes, or what their investment philosophy is, can increasingly feel like a mundane tick box exercise quickly covered by some generic, unfalsifiable answers. This really shouldn’t be the case. Investment beliefs are the foundation to any approach and will likely define its success or failure. An underwhelming process supported by some robust beliefs will likely do just fine, whereas flawed beliefs won’t be saved by a good process. The investment beliefs we hold should underpin any decision we make, without them it becomes incredibly difficult to make coherent choices – particularly during spells of market stress.

I have found recent volatility a good time to think about the beliefs that (currently) define how I think about investing. Here they are:

1) Financial markets are wildly inefficient but very hard to beat.

The notion that the aggregate actions of biased and imperfect investors somehow results in market prices being anywhere near ‘efficient’ has always seemed bizarre to me. The only reasonable way to reach such a conclusion is to argue that the ‘wisdom of crowds’ averages out our respective flaws; yet the wisdom of crowds idea only holds if its individual members are independent of each other (which investors are clearly not) and they are all trying to estimate the same thing. If you bring together a day trader, a long-term investor, a momentum investor, a passive investor and a contrarian investor – they are each investing in a different way with distinct objectives, there is no reason that their combined views should get us close to some long-term fair value.

That markets are likely to at times wildly diverge from any reasonable estimate of fair value does not necessarily mean that a more active approach is superior to a more passive one. To make the most of mispriced assets an investor needs to have skill and behavioural fortitude, characteristics that tend to be in short supply. If markets are indeed inefficient, our starting point should be that we are the ones creating the inefficiency rather than exploiting it.

2) Survival is the most important and neglected goal for all investors.

Investors rarely talk about survival, but it is the most important aspect of any strategy. It should define whether we make a particular investment and how it is sized. We should always avoid creating situations where there is a meaningful risk of complete disaster (being wiped out) or where we are unable to withstand spells of poor performance. The best investment is the one we can stick with for the long-run, not the one with the highest potential return. If we don’t survive, nothing else matters.

3) A long-time horizon is the great advantage of most investors, but few use it.

Most investors have long-term horizons but behave as if they are only interested in the next year (at most). This is a terrible waste of a huge advantage. In the short-run, financial markets are driven by sentiment, incessantly noisy and a complete behavioural disaster. They are not much more than a game where investors try to guess how other investors will react to the next piece of news. Over the long-run, more stable and dependable fundamentals like cash flows and profits start to exert their influence, and compounding works its magic. Most investors are too constrained by their psychological wiring and powerful industry incentives to make the most of this tremendous long-term edge.

4) Risk is about potential outcomes and probabilities.

Investors have a strange relationship with risk. We increasingly try to remove it while at the same time trying to take it. We also try to measure it via a host of imperfect means. The easiest and most useful way to think about risk is that it arises in any situation that has more than one potential outcome. A risky situation is simply one where there are several potential paths and some probabilities attached to them. The challenge, of course, is that we can never know with certainty the possible paths nor what the right probabilities are. But whenever we talk about risk – managing it, reducing it, increasing it – what we really mean is that we are trying to change the shape of future outcomes with all the uncertainty and trade-offs that this entails. We should be far more explicit about this.

5) Investors must define what is important and knowable.

The best way to navigate the vast amount of superfluous noise that has come to define financial markets is to ignore it. As that option is not available to many of us, the most feasible alternative is to define clearly the things that are important and knowable. Important things are those that matter to meeting our long-run objectives (and no, last quarter’s returns do not qualify) and being knowable means aspects we can predict with some confidence. If it is not important (and not many things are for long-term investors) we should ignore it. If it is important but not knowable then we can diversify to protect ourselves from the uncertainty.

6) Performance and valuation extremes are where most opportunities and threats exist.

Most price fluctuations in markets can be regarded as random noise and there is not much point in being one of thousands of other people attempting to attach convincing narratives to them. There are, however, certain situations where investor behaviour drives asset class performance and valuation to extreme levels – think bubbles, manias and crashes – where opportunities are created and downside risks are exaggerated. These extremes are a double-edged sword. Certain investors are able to take advantage of unusually compelling valuations and higher expected returns, while many others will be drawn into performance chasing – abandoning out of favour assets and becoming increasingly concentrated in expensive assets with unsustainably strong performance. Behaviour always matters for investors and matters even more at extremes.

7) Predicting macro and market developments is close to impossible, diversify instead.

It doesn’t matter how much evidence builds up that market forecasting is a destructive use of time; it will remain one of the most prominent parts of the investment industry. We can, however, benefit by simply not doing it – it gives us a head start over those that are. Forecasting and market timing is an attempt to deal with the ingrained uncertainty investors face, but it is the wrong answer. The correct response is diversification. The entire point of sensible diversification is to create a mix of assets that reflects the inherent uncertainty of the future.

8) If you want to understand anything in financial markets, think about incentives first and second.

As someone who has spent so much time applying behavioural science concepts, it always feels a little dispiriting to acknowledge that incentives drive most behaviour, but it is undoubtedly true. If we are ever in doubt about why something is being sold to us, why a group of investors are behaving in a certain way or how a geopolitical event is unfolding – the answer will almost always be found by following the incentives.

9) Most investment activity is some form of performance chasing.

Although nobody likes to admit it, and it gets camouflaged in many elaborate ways, the vast majority of investment activity across financial markets is performance chasing (it is amazing how many detailed investment processes and projects result in the recommendation of an asset class or fund that has performed very well in recent years). Everyone wants to own more of the things that are going up and less of the things that are going down. This is, of course, rational behaviour; not only does it appeal to our outcome-orientated psychology, but it is easier to raise assets / attract clients / not lose your job when you own the stuff that has been doing well.

Although there is some merit to momentum investing, performance chasing is not the same thing. It lacks all of its structure, discipline and explicit intent. All investors would be better off acknowledging their performance chasing tendencies, and trying to do less of it.

10) Our behaviour will define our outcomes; if we don’t think explicitly how to manage it, we are doomed to fail.

Humans are an exceptionally successful species, but most of our highly effective adaptations are incredibly ill-suited to making sound long-term investment decisions. It is not that we are irrational or stupid, just that we are applying our characteristic traits to an entirely different task – survival / reproduction has different requirements to making sensible investment decisions. Unless we think very deliberately and carefully about our investment behaviour, we don’t have much hope of good outcomes.

———

This set of beliefs has evolved through my career, which raises the question – how committed to our investment beliefs should we be? The answer is firmly enough that we don’t capitulate at the first moment of significant doubt, but with sufficient give that if enough pressure is applied, we might be inclined to change our mind. The tightness of grip on our own beliefs should also undoubtedly be related to our experience. The more that we have seen, heard, read and lived through should impact the confidence we may hold in our beliefs (though they should never be unimpeachable).

Ultimately, what we believe about how financial markets work will have an overwhelming influence on our investment results. We should all think a little more about what we believe and why.

—

---

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).