Tag Archives: nysearcaspy

Less Pain, More Gain

Summary Pain felt from losses far exceeds joy caused by gains — this psychological asymmetry is called loss aversion. The more often you check your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. If these emotions get the better of you, it can lead you to make investment decisions that you may later regret. This is why investors would do better (and be happier) if they monitored their performance less frequently. If it bleeds, it leads — bad news makes news; good news is no news. That’s the motto of today’s media. It’s no wonder people tend to think the world is always getting worse. But this asymmetry between bad and good is a much broader phenomenon. Our brains are in fact hardwired with a “negativity bias” — that is, we notice, remember, and give more importance to negative things than to positive ones. It’s why one little thing can ruin a good day. Why a reputation that takes decades to build can be destroyed by one mistake. Or why a single cockroach will completely wreck the appeal of a bowl of cherries, while a cherry will do nothing for a bowl of cockroaches. “Loss aversion,” or the tendency to weigh losses more heavily than gains, is another way this negativity bias manifests itself. Consider the following question: You are offered a gamble on the toss of a coin. If it comes up heads, you win $1,500. If it comes up tails, you lose $1,000. Would you accept this gamble? Although this gamble has a positive expected value of $250, you probably dislike it. And you’re not alone — for most people, the fear of losing $1,000 is more intense than the hope of gaining $1,500. In fact, numerous studies have shown that the average person won’t accept this gamble unless the potential gain is about $2,000, twice as much as the loss. This led researchers to famously conclude that “losses are twice as painful as gains are pleasurable.” That asymmetry between losses and gains has important implications for all investors. For instance, the more often you look at your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. The best solution, therefore, is to look at your portfolio as infrequently as possible. A simple example can illustrate this point. Let’s say you had invested $10,000 in the S&P 500 (NYSEARCA: SPY ) in January 1980. By the end of 2014, this would have grown to roughly $481,489 (which includes reinvested dividends) — an attractive return of 11.71% with a reasonable 16.76% volatility per annum. That return/volatility combination translates into a 76% probability of making money in any given year (and a 100% probability in any 10-year period). Sounds pretty good, right? But if you looked at your portfolio on a more frequent basis — say every hour — you’d have observed it making money only 50.65% of the time. In other words, even though you only had a 24% chance of losing money in any given year, the same portfolio when observed on an hourly basis would have disappointed you with losses 49.35% of the time. And since losses hurt twice as much as gains feel good, you’d be incurring a large emotional deficit by examining your performance at such a high frequency. This emotional deficit can actually be approximated mathematically. Simply assign a score of 1 for each positive return observation and a score of -2 for each negative return observation and then add them together to get a “reward-to-pain score.” The higher the score, the better. The table below shows that it’s not until we reach the annual portfolio observation that the reward-to-pain score turns positive. Checking your portfolio more frequently than that would cause you more emotional harm than good — which is why I shake my head when I see investors constantly monitoring their portfolios on their smartphones or tablets. It’s always easy to tell who’s making money and who isn’t (the look on their face says it all). Chances of Positive Returns on an S&P 500 Portfolio (1980 – 2014) Notes: (1) The above calculations assume that stock market returns are normally distributed (an imperfect but workable assumption). (2) Volatility is measured using the standard deviation of annual returns. (3) There are, on average, 252 trading days in a year and 6.5 hours in a regular trading day. (4) Reward/pain score = (1*probability of price increase) + (-2*probability of price decline). Source: A North Investments (“ANI”) Now let’s view this from another angle. The more frequently you look at your portfolio, the more randomness you’re disproportionately likely to get. In other words, you’ll see the short-term volatility of the portfolio, not the returns. This can be illustrated by taking the ratio of volatility to return at different observation frequencies (as shown in the table above). At a yearly observation frequency, the ratio is about 1.4 — or 59% randomness, 41% performance. But if you looked at the very same portfolio on an hourly basis, as many investors have a tendency to do, the composition changes to 98.4% randomness, only 1.6% performance. Yes, that’s right — you get over 60 times more randomness than performance! You’d be drowning in randomness and incurring emotional torture; it’s nearly impossible to make rational investment decisions under such conditions. The obvious moral here is that investors would do better (and be a lot happier) if they monitored their performance less frequently. Because the less often you look at your portfolio, the more likely it is that you’ll see gains. On the other hand, checking your portfolio more frequently increases the likelihood that you’ll see losses and hence suffer emotional distress. Avoiding the latter and focusing on the former prevents you from being fooled by short-term randomness — making it easier to stick to and achieve your long-term financial goals. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

With Further Market Declines Likely, Keep The Long Run In Mind

This article originally appeared on the Independent Observer Blog . August was the worst month for U.S. markets in more than three years, so say the headlines. I suspect it was also the worst month in at least that long for many international markets as well. And, as today’s numbers show us, we aren’t done yet. As I write this, U.S. markets are down about 2.5 percent, and European markets closed down around 3 percent. There is actually not much more I can add to what I’ve already written. Current valuations remain relatively high , and there is certainly the potential for further declines if the market adjusts to more typical valuation levels. From a correction standpoint, the S&P 500 is still down less than 10 percent from the peak. In other words, for all the hype and worry, we are in a market decline that, by historical standards, is both small and normal. This is not to minimize the current situation, however. Substantial technical damage has been done to U.S. markets, which remain below both the 200-day and 400-day moving averages. This suggests to me that more weakness is very likely. Indeed, the odds of a more substantial decline are, in my opinion, rising as confidence continues to erode. Many decision rules that have tested well in the past are now pointing to more declines as well. With further market declines likely, what should you do? If you have longer-term money invested (i.e., you don’t need it for 10 years or more), try to stay put. And if you’re still contributing to your portfolio, remember that the decline actually represents an opportunity, since you can invest at lower prices and benefit from potential future growth. If you have shorter-term money invested (i.e., you need it in the next couple of years), or if you’re already drawing down your portfolio in retirement, work with your financial advisor to determine what effect a large decline would have on your financial well-being. Hopefully, your portfolio is structured in a way that any decline will have minimal impact over time. If not, you might want to consider making changes to ensure that is the case. Once your portfolio design meets your needs, though, unfortunately, there is little left to do but buckle up and endure the ride. Why this decline looks different I won’t say enjoy the ride, of course, but to make it less painful, consider that this decline is different: First, many previous and major, long-lasting declines – 2000 and 2008 being the most recent – came at the end of multiyear debt-fueled booms. We might get to that point eventually, but we’re not there now. Households have actually continued to pay off debt during the past few years, not add to it. Second, sustained declines typically took hold during periods of recession while, today, the U.S. economy continues to grow in a sustainable way. Third, the lack of corrections like this over the past few years has, arguably, been unhealthy. The current decline is actually a painful but necessary step to clear out market excesses and lay the groundwork for further advances. This prescription – prepare and keep the long run in mind – is neither easy nor satisfying. The only real thing it has going for it is that, over time, it generally works. That is what I try to focus on, and I suggest you do the same.

How To Handle Market Crashes

While most investors think they are fully prepared for market crashes, this is easier said than done. Investors should always keep a part of their portfolio in cash and avoid the temptation of leverage. During market crashes many investors sell their stocks, usually the most profitable ones, even though their fundamentals have remained intact. This is a huge mistake. As Warren Buffett says, macro fears should never play a role in decisions to sell stocks. After 4 years of remarkably low volatility, the global markets crashed a few days ago, with S&P (NYSEARCA: SPY ) losing 200 points (about 10%) in just 4 sessions. The main reason was the increased concern that the Chinese economy might be decelerating from its current pace of about 7% annual growth. While most investors think they are fully prepared for such incidents, this is easier said than done and hence their mindset is really tested only when such events occur. In this article, I will provide a few guidelines for handling market crashes. First of all, investors should always keep a part of their portfolio in cash just for such incidents, which may be either widespread or specific for a single sector or stock. Investors normally prefer to be fully invested instead of keeping some cash because the latter results in underperformance during the good times of the market, as cash earns nothing. As the stock market does well most of the times (it rises slowly and falls steeply), it is only natural that investors tend to minimize their cash position. However, when a crash occurs, the resultant bargains are so great that they can provide exceptional profits in just a few days or weeks. Therefore, it pays to maintain a part of a portfolio in cash. For instance, Johnson & Johnson (NYSE: JNJ ), the popular dividend aristocrat that has raised its dividend for 53 years in a row, initially plunged 15% on Monday, August 24th, only to fully recover after 3 days. In a similar fashion, Gilead Sciences (NASDAQ: GILD ) initially plunged 18%, from $105 to $86, only to recover after 2 days. It is remarkable that its low of $86 corresponded to a forward P/E=7.4, extremely low for such an exceptionally managed, growing company. Similar trends were witnessed for other stalwarts as well, such as Visa (NYSE: V ), which initially plunged 16% on Monday, and MasterCard (NYSE: MA ), which initially plunged 19% on Monday. Both credit card companies fully retrieved their losses in 2 days. Instead of keeping some cash, some investors prefer to go to the other extreme and use some leverage in their portfolio. This is particularly enticing, as leverage helps them outperform the market during good times, i.e., most of the time. However, in the case of a crash, they will not have any spare money to take advantage of the rare opportunities that show up. Even worse, they may be forced to liquidate some positions at the most unfavorable moment. Therefore, not only do they miss the rare opportunities that emerge, but they also incur real, permanent losses due to the forced liquidation. In a mild market crash, like the one of last week, leveraged investors may lose profits of many months or years, depending on their degree of leverage. One might say that a 10% plunge can be tolerated even by high-leveraged investors but the truth is that no-one ever knows at what point the dive will end and hence high-leveraged investors are emotionally forced to liquidate positions even if they avoid a margin call. To put it simply, they prefer to cut their losses early, as a further decline of their stocks might be devastating for their portfolio. Apart from being fully invested, a common mistake during market crashes is to sell some stocks, particularly the most profitable ones. This is a huge mistake, which can prove to be very costly. If the fundamentals of a good stock have remained intact, the stock should not be sold during a market crash. Fears of an imminent recession or deceleration in the Far East or even the US do not count as fundamentals. If some investors are scared every time the media call for an imminent recession, these investors should never buy any stocks, as one thing is sure; a recession will show up in almost every country every few years. Therefore, selling solid stocks in a market sell-off is a recipe for failure. It is also a certainty that stocks with strong fundamentals will rebound quickly after the panic subsides and hence they will not be available near the prices recorded during the panic. To sum up, investors should keep a part of their portfolio in cash and avoid the temptation of leverage in order to take advantage of a market crash. Moreover, as long as the fundamentals of their stocks have remained intact, it will be a huge mistake to sell them. As Warren Buffett says, macro fears should never play a role in decisions to sell stocks. As the experience of all the previous market crashes (e.g. 1987, 2000, 2008, 2011) has shown, all the stocks with strong fundamentals soon retrieved their losses and most of them did so much faster than the market. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.