I want to talk to you about scary markets. For the sake of this particular subject, I want to be blunt and a little bit in your face. So for the next few minutes, please, just think of me less as your friend and more as your Scary Markets Drill Sergeant. O.K.? Great.
Now, you may be saying to yourself, “Why is he talking about this now? The markets aren’t even that scary.” That’s true. And it’s also true that I can’t predict when the next bad market is coming.
But I can predict that another bad market will come again, eventually. And when it does, you’ll want to have a plan. That’s precisely why now is such a good time to hash this out. Because you don’t wait until your house is in flames to buy a fire extinguisher, right?
Let me set the stage for you. It’s sometime in the near future. The market just got really scary, like 2008 or 2009 scary. You and I are sitting down together for lunch to talk about what you should do. We’re going to start with a couple of assumptions. First, you have a portfolio that was built specifically and intentionally to give you the greatest likelihood of reaching your goals. Second, your portfolio is down 20 percent or more, and you want to sell all of your investments and go to cash because that feels safest.
But before you do that, before you make this huge, drastic decision, I will have a little conversation with you. Here’s how that conversation would go.
Me: “Why are you invested the way you are?”
You: “Because this portfolio gives me the greatest chance of meeting my goals.”
Me: “Are your goals still the same?”
You: “Yes, they’re still the same.”
Me: “O.K., great. Step one, you own the right portfolio. Check.”
Let’s pause there a moment for dramatic effect and reiterate that you have the right portfolio. Back to the conversation.
You: “But I just can’t take it anymore! I’ve got to sell everything.”
Me: “Got it. Now, just so I understand, if you do that, is that going to be a permanent decision? In other words, are you getting out of the stock market forever?”
You: “Well, no…”
Me: “O.K., then. So when do you think you are likely to get back in?”
You: “When things settle down!”
Let’s hit pause again.
Now we know three very important things.
■ You have the right portfolio.
■ You’re not going to abandon the stock market permanently.
■ You’re going to reinvest when things clear up.
Let’s flesh this out a bit. I want you to imagine what it will be like when things clear up. So why don’t you go ahead and answer just a few more questions from your Scary Markets Drill Sergeant:
■ When the market clears up, will it be less scary than it is now?
■ When the market clears up, will the economy be better?
■ When the market clears up, will that guy on the financial pornography network be telling everyone and their mother to buy more stocks?
■ When the market clears up, will all your neighbors and friends be sitting around the barbecue grill again chatting about investing?
We all know the answers to those questions: yes, yes, yes and yes.
But one last question. Drum roll please: If the market isn’t scary, the economy is better, the guy on the financial pornography network is yelling “buy, buy, buy!” and everyone you know is planning to invest, how do you think the market then will compare to the market now?
It’ll be much higher, of course!
So, to review: Your plan is to sell your perfectly tailored portfolio, right now while your investments are down. Then, you’re going to wait until the market improves. When it does, you’re going to buy back Plan A at a much higher price.
To which I say: Seriously?
I hate to be annoying, but I really want to hammer this conversation home. It doesn’t make a lick of sense to sell a portfolio tailored for you when the market is low, and then buy it back when the market is higher. It makes infinitely more sense to simply keep your portfolio through the scary times and tough it out. Right, soldier?
Instead of doing what fear is making you want to do, just think back to your Scary Markets Drill Sergeant and remember these three things:
■ You made your portfolio based on your goals.
■ It still matches your goals.
■ If you sell that portfolio now and buy it back later when the markets are better, all you will do is lose money.
It’s that simple. Just. Don’t. Do it.
Think of this as something of a lifeboat drill. This is meant to help you remember that when the ship goes down and you find yourself in the lifeboat scared and cold, you don’t throw common sense to the wind and jump in the icy water. Just stay in the rescue boat, tough it out through the turbulent times and wait until the next big ship comes to pick you up to carry you safely to your destination.
This commentary originally appeared May 16 on NYTimes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Last week, we examined a study that found investors’ risk tolerance fluctuates positively with recent market returns. This behavior is in direct conflict with rational economic theory, which dictates that when market returns become negative, wealth contracts and risk aversion should therefore decrease (while risk tolerance should increase).
Instead, the authors found that investment losses, combined with loss aversion, contribute to an increase in risk aversion during bear market declines. On the other hand, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.
The findings from this study— Do Market Returns Influence Risk Tolerance? Evidence from Panel Databy Rui Yao and Angela Curl—suggest that individuals invest greater amounts after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor.
Today, we’ll examine some additional support for Yao and Curl’s conclusions, as well as explore the relationship between loss aversion and investor overconfidence.
Investor Risk Tolerance
To begin with, Yao and Curl’s findings are consistent with those of Michael Guillemette and Michael Finke, authors of the June 2014 paper, Do Large Swings in Equity Values Change Risk Tolerance?
Their study investigated whether the measured risk tolerance of U.S. and Canadian individuals correlated with market movements. Using a dataset provided by FinaMetrica, which creates and distributes a risk tolerance questionnaire widely employed by financial planners, the authors examined average monthly risk tolerance scores (MRTS) during the period from January 2007 through May 2012, a period that spans the financial crisis. A total of 341,782 people were surveyed over the time period. Their objective was to test whether fluctuations in equity returns influence average risk tolerance scores over time. The following is a summary of their findings:
Unfortunately for investors, their average monthly risk tolerance was also highly correlated with equity market valuations as measured by price-earnings (P/E) ratios. In fact, Guillemette and Finke found that risk tolerance increases when equity valuations are high (and expected returns are low), and that individuals are most risk-averse when equity valuations are low (and expected returns are high). This change in risk tolerance can lead to a buy high and sell low pattern of trading. As you would expect, this perverse behavior negatively impacts investor returns.
For example, Geoffrey Friesen and Travis Sapp, authors of the 2007 study Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability, found that individual investors lose, on average, 1.56% a year in dollar-weighted returns because they tend to pull money out of equity mutual funds following a significant market decline (when equity valuations are more favorable). Conversely, investors increase equity allocation following recent price increases (when valuations are less favorable).
As yet another example of recency’s impact, one that spanned the period of the financial crisis, the June/July 2011 issue of Morningstar Advisor looked at the behavior gap, the difference between the dollar-weighted returns earned by investors and the time-weighted returns earned by the mutual funds in which they invest, for the one-year and three-year periods ending December 2010. For domestic equity funds, the gap was 2% and 1.3% per year, respectively. For international equity funds, the gap was 0.6% and 0.8% per year, respectively.
Loss Aversion and Overconfidence
Shan Lei and Rui Yao, authors of the 2015 study Factors Related to Making Investment Mistakes in a Down Market, contribute to our understanding of investor behavior. They explored the following hypotheses:
To test their hypotheses, they used data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. The data was collected online by an independent market research firm between June 27, 2008, and July 18, 2008, in the midst of the financial crisis. The total sample size was 2,792 respondents. The survey asked participants for their reaction to the market changes during the past year. One question asked: “Since the market has changed over the past year, what actions, if any, have you taken?” One possible answer was: “Moving assets into more of a cash position.”
Lei and Yao considered it a mistake if investors moved assets into cash in a down market while having an adequate amount in an emergency fund. Because more loss-averse investors are more likely to react in a down market, those who chose these items as answers were considered to be more loss-averse investors. The following is a summary of the authors’ findings, all of which are consistent with findings already discussed:
Evidence From the U.K.
Since misery loves company, it’s nice to know that U.S. investors are not alone in their bad behavior. Thanks to Andrew Clare and Nick Motson—authors of the study Do U.K. Retail Investors Buy at the Top and Sell at the Bottom? have evidence demonstrating that investors in the U.K are equally guilty of bad or irrational behavior.
Clare and Motson examined the impact of timing decisions of both retail and institutional U.K. investors. The authors’ study covered the almost 18-year period from January 1992 through November 2009. The following is a summary of their findings:
The bottom line is that, over the 18-year period, the performance-chasing behavior of U.K. retail investors cost them a total return loss of 20%.
The Bottom Line
Warren Buffett has warned investors that their greatest enemy is looking at them in the mirror. Three of the most common and, unfortunately, most expensive mistakes that individual investors make are: overconfidence in their ability to withstand the stress of bear markets (which may lead to panicked selling), recency, and thinking that they are playing with the “house’s” money. These three are among the 77 mistakes covered in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them.”
But individual investors aren’t the only ones impacted by these problems. In his book, “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” Hersh Shefrin reported that the risk-tolerance levels of both institutional investors and financial advisors were positively correlated with stock market returns.
Having a sound understanding of risk tolerance is not only important for individual investors, but also for their financial advisors. The research shows that while advisors may treat investor risk tolerance as a stable characteristic, it’s clearly important to periodically revisit their clients’ risk tolerance, as risk tolerance changes not only as investors age but with movement in the markets as well. If an investor’s risk tolerance does change in response to market returns, it’s likely that either the investor (or the advisor) overestimated their ability to understand risk and properly assess their individual risk tolerance. And thus a change in the overall financial plan may be required.
This commentary originally appeared May 3 on MutualFunds.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
The recency effect—that the most recent observations have the largest impact on an individual’s memory and, consequently, on perception—is a well-documented cognitive bias. This bias could impact investment behavior if individuals focus only on the most recent returns and project them into the future. Such behavior may lead investors to experience a reduction in their risk tolerance (which, in turn, can lead to selling) after a bear market, when valuations are lower and expected returns are higher. Conversely, recency may lead investors to experience an increase in their risk tolerance (which, in turn, can lead to buying) after a bull market, when valuations are now higher and expected returns are lower.
The Recency Effect
The recency effect nudges investor behavior in a direction contradictory to economic theory, which states that relative risk aversion is a function of increasing wealth (the marginal utility of wealth declines as wealth increases). Strong market returns would increase investor wealth, and thus we should see a reduction in investor risk tolerance.
Rui Yao and Angela Curl—authors of a 2011 study, Do Market Returns Influence Risk Tolerance? Evidence from Panel Data, which appeared in the Journal of Family and Economic Issues—hypothesized that the recency effect would dominate rational economic behavior. They posited that risk aversion is negatively related to recent market returns (or, in other words, that risk tolerance is positively related to recent market returns).
Their study used data from the 1992, 1998, 2000, 2002 and 2006 interview waves of the Health and Retirement Study (HRS), an ongoing biannual study conducted by the University of Michigan and funded through the National Institute of Aging. The target population for the HRS is noninstitutionalized men and women, born from 1931 to 1941, living in the contiguous United States. Based on responses to a set of income gamble questions, researchers assigned participants to a risk tolerance level for each wave: most risk tolerant, second-most risk tolerant, third-most risk tolerant and least risk tolerant. Stock market performance was measured as a continuous variable using the S&P 500 Index’s trailing 12-month returns prior to each interview. The following is a summary of the authors’ findings:
Yao and Curl also found that:
The key finding is in direct conflict with rational economic theory. When market return becomes negative, wealth decreases. Therefore, risk aversion should decrease (and risk tolerance should increase). But Yao and Curl’s analysis found that risk tolerance fluctuated positively with market returns. While the loss of money, combined with loss aversion, contributes to an increase in risk aversion during a bear market decline, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.
The authors concluded that investors don’t behave according to rational economic model assumptions, and that “such changes in risk tolerance in response to market returns may be an indication that investors, and possibly their financial advisors, overestimate their ability to understand risk and assess individual risk tolerance.”
These findings suggest that individuals invest more after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor. Yao and Curl reached the conclusion that their findings support “the projection bias hypothesis and confirms the recency effect.” What’s more, their findings on investor behavior are consistent with those from the field of behavioral finance.
Behavioral Finance
For example, Richard Thaler and Eric Johnson, authors of the 1990 study Gambling with House Money and Trying to Break Even: The Effect of Prior Outcomes on Risky Choice, found that individuals experience less dissatisfaction from losses after a prior gain and greater dissatisfaction after a prior loss. Thus, risk aversion is time-varying and dependent on prior outcomes.
Yao and Curl’s findings are also consistent with those of Robin Greenwood and Andrei Shleifer, authors of a 2014 study, Expectations of Returns and Expected Returns. They were able to document a strong negative correlation between investor expectations of stock returns and recent returns for the S&P 500—investors change their expectations of the reward from taking risk based on recent changes in stock market returns.
The financial crisis of 2008 provided a good example of how recency impacts investor risk tolerance. During the crisis, individual investors pulled out hundreds of billions of dollars from the equity market. The result was that, by 2010, portfolio allocations to risky assets had declined to their lowest level for people under the age of 35 in the history of the Survey of Consumer Finances.
A more recent example can be found by examining the returns from emerging markets and investor flows. From September 2014 through September 2015, the MSCI Emerging Market Index lost more than 23%.Investment Company Institute data shows that beginning in July 2015, emerging-market funds experienced net withdrawals in every single month. For the period from July 2015 through January 2016, total net withdrawals exceeded $13 billion.
Next week, we’ll examine some additional support in the research for Yao and Curl’s findings, as well as explore the relationship between the recency effect and loss aversion and investor overconfidence.
This commentary originally appeared April 26 on MutualFunds.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE