This week's European Union (EU) referendum has polarised public opinion on issues like economics, immigration and sovereignty. But for stock market investors there are some other potentially costly outcomes that hang on the result.
Analysts generally agree that the uncertainty of a Brexit vote could cause a lengthy period of market volatility. In other words, share prices may fall hard.
But a vote to remain in the EU will arguably see a quick bounce in confidence for equities. In fact, prices might even rally.
Either way, the outcome is far from predictable. So it's worth taking a moment to consider whether it's really worth making impulsive trading decisions based on what the result might be.
WHY HUMANS HATE LOSSES
In behavioural science, psychologists have found that the average human feels the pain of a loss much more than the satisfaction of a win. It's an instinct blamed for the fact that investors often sell winning holdings too quickly and hold losing positions too long.
In essence, taking a loss on a disappointing share is mentally much harder than creaming off profits from a winner. That's despite the fact that this sort of trading has been proven to damage portfolio returns.
Fear of loss is made worse by the fact that investors are also prone to thinking in the short term and watching their portfolios like hawks. When you combine these two behavioural traits, you end up with a depressing-sounding cognitive bias called Myopic Loss Aversion.
You don't need to be a behavioural expert to get to grips with the risks of myopic loss aversion. Research reveals some very simple conclusions.
The first is that investors watch the performance of their shares far too often. And when they do, they tend to get scared by what they see and sell up quickly.
Part of the issue - as shown by two titans of psychology, Amos Tversky and Daniel Kahneman - is that stocks are naturally volatile in the short term.
But over the long term, they outperform most other assets. So short-term thinking can shake investors out of stocks at the wrong moment.
This problem was tackled in a classic quote by investing legend Warren Buffett - a man not easily shaken by price swings: 'If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong.
'Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.
This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.'
Implicit in that quote is Buffett's view those with an investment horizon of at least five years shouldn't be concerned about near-term price movements. On the eve of the EU referendum, and the uncertainty about where prices will move, it might be worth taking note of Buffett's advice.
SCREENING FOR QUALITY SHARES
With this in mind, this week we've picked up on Buffett's focus on business and financial quality.
Typically, his favoured companies have the traits of what he calls an economic 'moat'.
They're able to protect themselves from competition and market pressures, which mean they can command high operating margins and generate high levels of free cash flow (FCF), which can be invested or paid out in dividends.
Those investments produce strong returns, which can be seen in measures like return on capital employed (ROCE).
We also included Stockopedia's broad-based assessment of a firm's quality, called the QualityRank, which scores and ranks all companies in the market according to their financial and business strength - from zero (low) to 100 (high).
|Name||Forecast p/e ratio (times)||Forecast yield (%)||FCF/sales (%)||ROCE (%)||One-year relative strength||Quality Rank|
|Jupiter Fund Management||14.5||5.8||36.5||26.8||7.5||98|
|Wizz Air Holdings||12||-||16.4||25.3||33.4||95|
Unsurprisingly, these rules identify names that are regarded as some of the best quality companies in the market.
Among them are price comparison service Moneysupermarket, fund management giant Jupiter and pizza chain Domino's. Typically, they are highly profitable and resilient to competition.
Others on the list include chipmaker ARM, housebuilder Persimmon, property portal Rightmove, home products group Reckitt Benckiser and financial trading firm IG.
PREPARING FOR UNCERTAINTY
There is no doubt that that the unpredictable outcome of the EU referendum leaves investors facing huge uncertainty.
While risk appetite and investment decisions are entirely personal, it's worth remembering that times of stress can lead to emotional decisions that may end up proving costly in the long run.
Warren Buffett's preference for 'moat-like' qualities in a business can mean that those types of stocks are frequently on very rich valuations.
But they're often expensive, for the good reason that they're better able to withstand short-term knocks - and so are their investors.
Ben Hobson is investment strategies editor at Stockopedia.com, the rules-based stock market investing website. He is also the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook". Click here to enjoy a completely FREE 5-day trial of Stockopedia.
This article was written for our sister website Interactive Investor.
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