Optimism Bias and the Illusion of Knowledge

Investors start each year determined to do better. With hindsight, last year’s mistakes always look obvious – surely we can learn from them. The second-half of 2011 was a dreadful period for small and mid cap companies, hitting most actively managed portfolios. Yet, history repeats; as with last year, the January effect has prevailed. Smaller companies have beaten the FTSE 100 over the month, in a triumph of emotion over reality. Given the poor long term record of small cap, investors should by now have fallen out of love with the sector. Can behavioural finance help us understand what is going on?

The FTSE 100 Index has recovered to its levels of last summer, but smaller companies have lagged by more than 10% on average. Mid cap shares are only slightly better. This underperformance is particularly disappointing, as it includes December and January, often the best months for smaller companies.

The longer term picture is poor. The Small Cap Index is behind the FTSE 100 over 10 years; investors have not been rewarded for the higher level of risk involved. Returns in small and mid cap need to be better to recognise additional research, dealing costs and lower liquidity.

This weakness in second-line stocks explains many managers’ disappointing performance last year. Active portfolios are typically overweight in these stocks, with managers believing they have an edge in stockpicking where companies are less intensively researched. Growth expectations are higher, too.

Behavioural finance recognises this failing as the illusion of knowledge – belief that more information can boost returns. Instead, it usually just increases confidence. Investors can be distracted from looking at numbers objectively, as paying too much attention to the language and enthusiasm of company management. Information given in company meetings can distract. Too much weight can be given to the vividness of detail, which is difficult to verify or compare objectively between companies.

Analysis tends to focus on the apparent uniqueness of potential in a company, rather than the background environment. The impact of credit tightening currently is often overlooked, until managers get the call about an unexpected fundraising. Recently there have been more of these nasty surprises. This is a difficult stage in the business cycle, made worse by banks’ deleveraging. Sustained recovery in the sector is likely to need M&A, a credit easing or a fall in the Pound. Smaller companies have most to lose from bank deleveraging, and are more exposed to a European recession. Tight credit may also keep bids and mergers off the agenda.

Institutional investors are less enthused now about refinancing. Funds with big stakes in small cap stocks are watching market liquidity drain away. Stockbroking research is under pressure; lower market activity means less research and market-making. And, supporting share issues now could mean institutional investors becoming locked-in. Many funds, such as UCITS, need to demonstrate liquidity in portfolios. If shares are not actively traded, managers may be forced to sell.

Analysts often also show a bias to optimism. This time last year, growth of 17% was forecast for mid cap earnings for 2011. The actual outcome was just 2%. Earnings expectations for 2012 seem similarly unrealistic, looking for 20% growth. Yet, profit margins in small and mid cap companies are already near historic highs. How much further can they stretch?

Undoubtedly, many smaller companies are well managed, but a good company may not be a good investment. The danger is that fund managers focus too narrowly on results and forecasts; the challenging environment may not be factored into their calculations.

Small cap is a good story, easily sold to advisers and their clients. The opportunity for growth and original research makes investors feel warmly about the sector. But, overall smaller companies may not be worth the risk at this stage in the business cycle. Investors should not let emotions get in the way of rational judgement; it is time to realistically assess risk and reward.