A good friend, Sherman Doll, related the following story. Sherman has been a two-line sport kite flier for years. While not a pro, he has learned a few tricks from observing the flying behavior of these kites. He told me that one of the most difficult skills for beginners to master is what to do when their kite starts to plunge earthward.
The natural, panicky impulse is to yank backward on the lines. However, this action only accelerates the kite’s death spiral. The effective, kite-saving technique is to calmly step forward and thrust out your arms. This causes the kite’s downward acceleration to stop, allowing you to regain control and end its plunge.(1)
What does this have to do with investing?
As you likely know, the S&P 500 Index dropped 579 points from its closing high of 2,930 on September 20 to finish at 2,351 on December 24, a price drop (not including the return from dividends) of 19.8 percent — just short of the technical definition of a bear market, which is a loss of 20 percent. Combined with the weak performance of global equities over the same period, geopolitical turmoil in various corners of the world (including the risk of a trade war with China), President Trump’s attack on Federal Reserve Chairman Jerome Powell, and the government shutdown, the stomachs of many investors started to rumble.
Over the almost 25 years that I’ve been working with investors, I’ve learned that when we have situations like the one we’re in now, many people begin to “catastrophize.” They begin to focus solely on the negative news, ignoring all the good economic news.
- Economic growth is strong. The Federal Reserve Bank of Philadelphia’s Fourth Quarter 2018 Survey of Professional Forecasters projects real GDP growth of 2.7 percent for 2019, down just slightly from the forecast of 2.9 percent for 2018.
- Unemployment is at 3.7 percent, the lowest rate in 50 years.
- Inflation is moderate. The Philadelphia Fed’s latest 2019 forecast is for an increase of 2.3 percent in the Consumer Price Index (CPI), down slightly from its forecast of 2.4 percent for 2018.
- Consumer sentiment (a leading indicator) is strong. The final December University of Michigan Consumer Sentiment Survey came in at 98.3, remaining near the highest levels we have seen over the past 18 years (despite the recent weakness in stocks). The last time the Consumer Sentiment Index was consistently above 90.0 for at least as long was 1997 through 2000, when it recorded a four-year average of 105.3.
- New claims for unemployment continue to be at very low levels. In the week ending December 22, the advance figure for seasonally adjusted initial claims was just 216,000.
Ignoring the good news, and focusing only on the market’s drop, causes many investors to begin anticipating everything that could possibly go wrong. Such investors end up in a loop of worry and anxiety that leads at best to indecisiveness and at worst to panicked selling.
Returning to my friend’s story about flying kites. Just as when a kite starts to plunge earthward and the natural, panicky reaction is to yank backward on the lines, the natural, panicky reaction to a dive in your portfolio’s value is to pull back (sell). In both cases, pulling back is the wrong strategy. The right strategy is the less intuitive one. It involves the choice to remain calm and step forward (buying stocks to rebalance your portfolio back to your desired asset allocation).
Warren Buffett, probably the most highly regarded investor of our era, has offered the following wisdom over the years. Listen carefully to his statements regarding efforts to time the market.
• “Inactivity strikes us as intelligent behavior.”
• “The only value of stock forecasters is to make fortune-tellers look good.”
• “We continue to make more money when snoring than when active.”
• “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
Finally, Buffett recommends that if you simply cannot resist the temptation to time the market, then you “should try to be fearful when others are greedy and greedy only when others are fearful.” In other words, stick to your plan by rebalancing, which requires buying when others are panicking.
Perhaps the greatest anomaly in finance is that while investors idolize Buffett, they not only fail to follow his advice, but often do exactly the opposite of what he recommends.
While it is tempting to believe that there are those who can predict bear markets and, therefore, sell before they arrive, there is no evidence of the persistent ability to do so. On the other hand, there is a large body of evidence suggesting that trying to time markets is highly likely to lead to poor results. For example, in his book “Investment Policy,” Charles Ellis discussed a study on the performance of 100 pension plans that engaged in tactical asset allocation (a fancy term for market timing, allowing the purveyors of such strategies to charge high fees). It found that not a single plan benefited from the effort. That is an amazing result, as even random chance would lead us to expect at least some to benefit.
Avoiding Investment Depression
If you’re prone to investment depression, one way to help avoid the downward spiral that many investors experience (which can lead to panicked selling) is to envision good outcomes. To help you do just that, I have gone to my trusty videotape and come up with some data that should not only be of interest, but should also enable you to envision positive outcomes.
Over the last 78 years, we have experienced four quarters in which the S&P 500 Index lost more than the 20 percent — the four quarters ending September 1974 (-25.2 percent), December 1987 (-22.6 percent), December 2008 (-21.9 percent) and June 1962 (-20.6 percent). Over the next 12 months, returns ranged from 17 percent to 38 percent (averaging 28 percent); over the next 36 months, returns ranged from 49 percent to 73 percent (averaging 60 percent); and over the next 60 months, returns ranged from 95 percent to 128 percent (averaging 112 percent).
There’s another way to reduce the risk of investment depression.
Myopic Loss Aversion and the Pain Ratio
Nobel Prize winner in economics, Richard Thaler, author of the book “Misbehaving,” has found that we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This tendency leads to the behavior known as “myopic loss aversion,” creating a problem for investors who check their portfolio values on a frequent basis.
Consider the following: Based on the historical evidence for the S&P 500 Index (1950–2014), investors who check their portfolios on a daily basis can expect to see losses 46 percent of the time and gains 54 percent of the time. However, while they see gains more frequently than losses, because we tend to feel the pain of loss with twice the intensity that we feel joy from an equal-sized gain, the more often we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will be -38 ([-46 x 2] + [54 x 1]).
Over the period 1927–2014, investors who resisted checking their portfolio daily, and instead moved to a monthly check, experienced losses only 38 percent of the time. That reduced the net pain reading from -38 to -14 ([-38 x 2] – [62 x 1]).
Over the same 1927–2014 period, losses occurred only 32 percent of the time on a quarterly basis. Thus, investors who reviewed their values quarterly (like many who participate in 401(k) plans and receive quarterly statements) experienced a shift from net pain to a net joy reading of +4 ([-32 x 2] + [68 x 1]).
Investors whose patience and discipline allowed them to check values only on an annual calendar year basis experienced losses just 27 percent of the time. That results in a big improvement in the net reading, from +4 to +19 ([-27 x 2] + [73 x 1]).
As you would expect, the frequency of losses continues to diminish over time. Using overlapping periods, from 1927 through 2014, the frequency of losses at a five-year horizon falls to just 14 percent. That results in a pain/joy reading of +58. At a 10-year horizon, the frequency of losses falls to just 5 percent. That creates a pain/joy reading of +85 and will make for a happy (and more disciplined) investor.
If you’re a masochist, the implication for you is that you should check the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are many. First, the more frequently you check your portfolio, the less happy you are likely to be, as well as less able to enjoy your life. Second, all else equal, the less frequently that you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan to avoid pain.
The bottom line is that if you cannot resist frequently checking your portfolio’s value, you should be more conservative because you will be feeling the pain of losses more frequently. Feel enough pain, and even the most well-thought-out investment plans can end up in the trash heap of emotions.
There’s another important message here. The less you watch and/or read the financial media, and the less you pay attention to economic and market forecasts (because they can cause you to imagine pain), the more successful investor you are likely to be!
Warren Buffett has accurately stated that “investing is simple, but not easy.” (outlined in great detail by Wes, here) The simple part is that the winning strategy is to act like the lowly postage stamp, which adheres to its letter until it reaches its destination. Similarly, investors should stick to their asset allocation until they reach their financial goals.
The reason investing isn’t easy is that it can be difficult for many individuals to control their emotions (greed and envy in bull markets and fear and panic in bear markets). In fact, I’ve come to believe that bear markets are the mechanism by which assets are transferred from those with weak stomachs and without an investment plan to those with well-thought-out plans—meaning they anticipate bear markets—and the discipline to follow to those plans.
A necessary condition for staying disciplined is to have a plan to which you can adhere. But that’s not sufficient. The sufficient condition is that you must be sure your plan avoids taking more risk than you have the ability, willingness and need to take. If you exceed any of those, you just might find your stomach taking over the decision-making. If you don’t have a plan, develop one. If you do have one, and it’s well-thought-out, stick to it.
- The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
- Join thousands of other readers and subscribe to our blog.
- This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.
References [ + ]
|1.||↑||Editor’s Note: Wes, who was cajoled into learning how to kitesurf by his younger brother, can confirm this is 100% true after multiple faceplants into the water at high speed.|