If you could read my mind

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  By Guest Blogger Doug Rowat

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Bob Dylan once called Gordon Lightfoot his “mentor” and famously said that every time he hears one of his songs he wished “it would last forever”. Can a songwriter receive higher praise than that? So, yeah, Gordon Lightfoot’s a legend.

However, Lightfoot learned quickly not to be pretentious about his ‘art’. He was practical when it came to making a buck. When discussing his mega-hit “If You Could Read My Mind” in the 2019 documentary of the same name, he highlighted how the record executives wanted to change the name of his album from the utterly forgettable Sit Down Young Stranger to If You Could Read My Mind because the song was starting to receive significant radio airplay. Lightfoot initially resisted, but when the executives explained that the name change would dramatically increase sales, which it did, he “kept [his] mouth shut from then on.”

So it was Lightfoot’s practicality as well as his talented songwriting that allowed him to sell 10 million albums and live next door to Drake.

So what’s the lesson here? You can be stubborn and morally superior, but it’ll likely cost you. Investors who are fixated on overweighting ESG investments, for example, should recognize this. I’m not opposed to ESG investing. In fact, I’ve discussed here before ESG’s massive potential and highlighted the positive influence that it can have on company behaviour. But evidence that ESG mandates achieve better performance is starting to wane. ESG indices, for example, generally have lower weights to such cyclical sectors as energy, and depending on where we’re at in a market or commodity cycle, this can significantly dampen performance.

As one example, the S&P/TSX Composite ESG Index, which is, of course, underweight energy, has continuously underperformed the plain-vanilla S&P/TSX Composite Index since its launch almost three years ago. It amounts to more than a two percentage-point underperformance annually:

S&P/TSX Composite index (white line) vs S&P/TSX Composite ESG Index (blue line)

Source: S&P. “LD” refers to July 2020 launch date of the S&P/TSX Composite ESG Index.

While I would argue with the environmentally woke crowd that their carbon footprint is probably far greater than they think, they also need to be aware that by taking the moral high ground with their investments they may end up a lot poorer. For most, this is an unpleasant sacrifice.

But it’s not just the steadfast treehuggers who pay a price for being inflexible. Stubbornness costs all investors. A perfect example? Anchoring. Anchoring refers to the behavioural bias of fixating on the first information that we’re presented with and then not budging. Usually, this involves investors getting ‘anchored’ to the original price that they paid for a security. If the security’s price declines, anchored investors stubbornly continue holding it until the original purchase price is realized again.

The problem with anchoring, of course, is that it’s arbitrary. It doesn’t involve a carefully considered forecast. It ignores any likelihood, for instance, that the price could continue to decline or that a replacement investment might perform better. Unfortunately, for the victims of anchoring bias, the first purchase price gets equated with ‘fair value’. But, of course, it’s not fair value. It’s simply a number.

If you want an example of how we become anchored to the first information that we’re presented with and how it can distort our thinking, consider this study by behavioural economics pioneers Amos Tversky and Daniel Kahneman. They asked high school students to estimate, within five seconds, the product of the following two number sequences:

8 x 7 x 6 x 5 x 4 x 3 x 2 x 1
1 x 2 x 3 x 4 x 5 x 6 x 7 x 8

Naturally, the actual product for each sequence is identical (40,320), but the median estimate for the first string was 2,250, but for the second only 512. The students anchored their estimates to the size of the first numbers in the sequence.

Book editors are fond of saying to writers: “don’t fall in love with your babies”. Writers must be prepared to change sentences, paragraphs and, in some cases, entire chapters in order to make their manuscript better. In other words, writers can’t become anchored to first drafts. And so it is with investing: investors can’t become anchored to initial information or initial purchase prices. Sometimes you have change a portfolio—kill a few babies—to make it better.

By changing his album’s name, Gordon Lightfoot killed his baby and shed an anchor. And, as a result, got a whole lot richer.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.