My friend Andy used to be completely obsessed with the stock market. He rode the dot-com bubble all the way up and felt the crushing blows on the way down. He found himself right back in the fray until a little over two years ago, when his 40 year old wife died suddenly. Since then Andy admits that he has become a much better investor.
How could such a tragedy transform his financial acumen? The answer lies in the deep emotional current that swirls in every investor’s mind and belly. In the past, Andy would watch each position, tick for tick. He would often experience a kind of euphoria when a trade went well, only to second-guess himself when it went sour. He knew that it was a debilitating cycle, but he could not get out of it.
Then the unimaginable occurred, putting him and his whole family through a nightmare. After his wife’s death, Andy did not have the same passion for investing. He stopped watching CNBC every day and monitoring his accounts on a minute-by-minute basis. Instead, he would call me every quarter or so to discuss the overall economy and asked for advice about general market trends. He no longer purchased individual securities, turning instead to index funds and even began to use bonds and commodities in the portfolio to help diversify some of the risk. Interestingly enough, his performance improved, both on the upside and the downside.
When we met for lunch on Friday, he said that he was not worried about the stock market or even the economy. “Of course it’s terrible for people to lose jobs and for families to suffer, but I am convinced that we’ll get through this period. This country has been through worse—heck, I have been through much worse and you know what I found out? That I can survive the worst and still wake up the next morning to see the sun shining and the world turning. Tell your blog readers, radio listeners and everyone on TV that Andy says that everything is going to be OK.”
It seemed fitting that when Andy and I were having lunch, the stock market was down a touch, but by the end of the day, it reversed course and experienced a powerful rally. The Dow closed 494.13 points higher, up 6.5%, at 8046.42 and the S&P 500 was up 6.3% to 800.03. Yes, it was a terrible week, but for at least one day, Andy was right: everything was OK. It’s not a bad lesson for the rest of us: a little distance might help everyone get through this with more of our wits about us.
Showing posts with label risk. Show all posts
Showing posts with label risk. Show all posts
Monday, November 24, 2008
Tuesday, October 14, 2008
The Mother of all Rallies
For those who panicked last week, take heart…the stock market may have lurched forward yesterday, but it just as easily could have dropped once again. It only took Mitsubishi backing out of its investment into Morgan Stanley or maybe another hesitating weekend of inaction by the world’s finance ministers. That said, many investors learned a painful lesson yesterday: for relief in the moment, you may have chosen a path that could (or could not) have long term ramifications.
In Ron Lieber’s recent New York Times article “Switching to Cash May Feel Safe, but Risks Remain,” (October 8, 2008), he cites 2005 research conducted by H. Nejat Seyhun, a professor of finance at the Ross School of Business at the University of Michigan. Seyhun “tested the long-term damage that investors could do to their portfolios if they missed out on the small percentage of days when the stock market experienced big gains. From 1963 to 2004, the index of American stocks he tested gained 10.84 percent annually in a geometric average, which avoided overstating the true performance. For people who missed the 90 biggest-gaining days in that period, however, the annual return fell to just 3.2 percent. Less than 1 percent of the trading days accounted for 96 percent of the market gains.”
Let’s take a look at this in real time. Friday capped the worst week ever for US stocks. The major indexes plunged over 18% in just five trading sessions. Then yesterday, the Dow Jones Industrial Average soared 936.42 points, or 11.1%, to 9387.61. The S&P 500 soared 12% to 1003.35, with all its sectors climbing. The Nasdaq Composite Index rose 12% to 1844.25 and the small-stock Russell 2000 jumped 9.2% to 570.55. Stock markets around the globe put in similar performances. Of course stocks are still mired in a serious bear market, with the Dow still down 29% year to date and off 34% from its record close of 14164.53 hit just over a year ago on October 9, 2007.
Indeed, a good night’s sleep is a precious commodity. But it is also important to remember that emotional decisions often can have a payback. You may have felt better over the weekend after going to cash, but how are you doing now? Are you still comfortable knowing that you missed the biggest percentage gain in US stock history? As Lieber notes, “some retirees, or those close to leaving the work force, may be well-off enough to leave stocks behind for now. If the tumult in the economy and the decline in the markets have altered your risk tolerance, then it may make sense to move to a portfolio of Treasury bills, certificates of deposit and money market funds.” But if you are a long-term investor, you should try to avoid the herd mentality that is associated with bull and bear markets.
Burton Malkiel, the legendary author of “A Random Walk Down Wall Street,” reminds us that “the herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every "light at the end of the tunnel" is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period. Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.”
Whether or not last week was the bottom of the stock market move will only be known in retrospect. One way that you may know that your asset allocation is consistent with your risk tolerance is if you felt as calm last Friday and you are today. If that’s the case, the “Mother of all Rallies” was just another Monday.
In Ron Lieber’s recent New York Times article “Switching to Cash May Feel Safe, but Risks Remain,” (October 8, 2008), he cites 2005 research conducted by H. Nejat Seyhun, a professor of finance at the Ross School of Business at the University of Michigan. Seyhun “tested the long-term damage that investors could do to their portfolios if they missed out on the small percentage of days when the stock market experienced big gains. From 1963 to 2004, the index of American stocks he tested gained 10.84 percent annually in a geometric average, which avoided overstating the true performance. For people who missed the 90 biggest-gaining days in that period, however, the annual return fell to just 3.2 percent. Less than 1 percent of the trading days accounted for 96 percent of the market gains.”
Let’s take a look at this in real time. Friday capped the worst week ever for US stocks. The major indexes plunged over 18% in just five trading sessions. Then yesterday, the Dow Jones Industrial Average soared 936.42 points, or 11.1%, to 9387.61. The S&P 500 soared 12% to 1003.35, with all its sectors climbing. The Nasdaq Composite Index rose 12% to 1844.25 and the small-stock Russell 2000 jumped 9.2% to 570.55. Stock markets around the globe put in similar performances. Of course stocks are still mired in a serious bear market, with the Dow still down 29% year to date and off 34% from its record close of 14164.53 hit just over a year ago on October 9, 2007.
Indeed, a good night’s sleep is a precious commodity. But it is also important to remember that emotional decisions often can have a payback. You may have felt better over the weekend after going to cash, but how are you doing now? Are you still comfortable knowing that you missed the biggest percentage gain in US stock history? As Lieber notes, “some retirees, or those close to leaving the work force, may be well-off enough to leave stocks behind for now. If the tumult in the economy and the decline in the markets have altered your risk tolerance, then it may make sense to move to a portfolio of Treasury bills, certificates of deposit and money market funds.” But if you are a long-term investor, you should try to avoid the herd mentality that is associated with bull and bear markets.
Burton Malkiel, the legendary author of “A Random Walk Down Wall Street,” reminds us that “the herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every "light at the end of the tunnel" is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period. Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.”
Whether or not last week was the bottom of the stock market move will only be known in retrospect. One way that you may know that your asset allocation is consistent with your risk tolerance is if you felt as calm last Friday and you are today. If that’s the case, the “Mother of all Rallies” was just another Monday.
Monday, October 13, 2008
Hedonists and Risk re-raters
People are scared by the tumbling markets and in some cases, they should be. They made decisions over the past three or four years that have made them less equipped to deal with the current market and economic situation. In fact, I can actually pinpoint those who are in full freak-out mode while the majority of others are clearly concerned, but not spinning out of control and making rash decisions.
The two categories of people that seem to be in full-fledged hysteria are: the hedonists and the risk re-raters. Let’s start with the former. Over the course of the past decade or so, hedonism had made a revival in America. There was the hyper-focus on living it up, enjoying the best there is and even a resort called “Hedonism.” The good times were fueled by two asset bubbles -- the stock and housing markets -- and were super-charged by ultra-low interest rates.
The hedonists lived beyond their means—they chose to purchase homes that were too expensive; went out to dinner, bought fancy cars and vacationed instead of saving more in their retirement accounts; decided to retire too early; and simply spent too much money. I spoke to a couple who never would have considered themselves as hedonists, but indeed they are. Three years ago, they started to talk about their longer term goals. They planned to work for 5-10 years, leave the Northeast and relocate down south.
But then the housing market exploded and all of their friends were buying land and condos and they wanted in on the action. They called me after they had placed a $70,000 down payment on a piece of land and informed me that they intended to rent out the place down south until they were ready to retire. Flash forward to today and you know the story: the $600,000 house is almost complete, nobody is interested in renting and they are now carrying two homes with two mortgages and are that much closer to retirement. Is it any surprise that this couple is not sleeping as they watch their portfolio drop from $1,000,000 to $850,000? Believe me when I tell you that they do not want to hear that they are “only” down half the amount of the overall stock market. They are paying for their desires now and it hurts badly. Chances are hedonists would feel far better about the value of their investment accounts if they had not overextended themselves in the period prior to this one.
The “Risk re-raters” are a different genus. These are the investors who were happy to assume risk in their portfolios as long as the market was moving in the “right” direction. They tended to be among the more annoying clients in a rising market environment ---“Can’t we do better? I think we should own more (fill in the blank of the asset class that was up the most in the prior year) to improve our returns!” The dutiful advisor would talk about what happens when the market goes down, warning that while it is great to assume more risk when things are going well, it doesn’t feel so hot when the markets move in the opposite direction. This is usually met with a nodding head and then a rush to sign new paperwork and increase the risk levels.
As the down market turns into a raging bear market, these are among the first people we hear from—they are worried that their growth (what exactly did they think “growth” meant?) portfolios are down “so much.” Forget trying to explain that they are not down nearly as much as the market, or even to remind them that they had made this decision against all better judgment. These are among the first people who want OUT immediately and who say that they will get back in when “things settle down.”
This occurred with a client I will call “Jane,” who retired from working full time four years ago at the age of 58. At the time, she had a pile of money and I advised taking a less risky approach to her portfolio, because she could—meaning that because she had done the hard work of accumulating $4,000,000, she did not have to go beyond being a balanced investor over the next thirty years or so. After the first year, she came in for a meeting with one goal in mind: she wanted to earn more on her investment account so that she could stop working part-time. She recounted how friends of hers were doing much better with their money and that she wanted in on the action. She pushed all of the warnings aside, quit her job, increased the risk and then when the September massacre occurred, she pulled out of everything—completely!
The moral of this column is not to make people feel bad about losing money in the markets—we are all in the same boat on that front. Rather this is an important reminder that the decisions we make in our lives can often be the difference between being able to weather the storm and enjoying a good night sleep and succumbing to emotions and making another set of bad decisions. That is perhaps the silver lining for those of us in the advice-giving business…maybe this current cycle of lessons will finally help shift behavior in the future and prompt people to make more prudent financial decisions in our next phase.
The two categories of people that seem to be in full-fledged hysteria are: the hedonists and the risk re-raters. Let’s start with the former. Over the course of the past decade or so, hedonism had made a revival in America. There was the hyper-focus on living it up, enjoying the best there is and even a resort called “Hedonism.” The good times were fueled by two asset bubbles -- the stock and housing markets -- and were super-charged by ultra-low interest rates.
The hedonists lived beyond their means—they chose to purchase homes that were too expensive; went out to dinner, bought fancy cars and vacationed instead of saving more in their retirement accounts; decided to retire too early; and simply spent too much money. I spoke to a couple who never would have considered themselves as hedonists, but indeed they are. Three years ago, they started to talk about their longer term goals. They planned to work for 5-10 years, leave the Northeast and relocate down south.
But then the housing market exploded and all of their friends were buying land and condos and they wanted in on the action. They called me after they had placed a $70,000 down payment on a piece of land and informed me that they intended to rent out the place down south until they were ready to retire. Flash forward to today and you know the story: the $600,000 house is almost complete, nobody is interested in renting and they are now carrying two homes with two mortgages and are that much closer to retirement. Is it any surprise that this couple is not sleeping as they watch their portfolio drop from $1,000,000 to $850,000? Believe me when I tell you that they do not want to hear that they are “only” down half the amount of the overall stock market. They are paying for their desires now and it hurts badly. Chances are hedonists would feel far better about the value of their investment accounts if they had not overextended themselves in the period prior to this one.
The “Risk re-raters” are a different genus. These are the investors who were happy to assume risk in their portfolios as long as the market was moving in the “right” direction. They tended to be among the more annoying clients in a rising market environment ---“Can’t we do better? I think we should own more (fill in the blank of the asset class that was up the most in the prior year) to improve our returns!” The dutiful advisor would talk about what happens when the market goes down, warning that while it is great to assume more risk when things are going well, it doesn’t feel so hot when the markets move in the opposite direction. This is usually met with a nodding head and then a rush to sign new paperwork and increase the risk levels.
As the down market turns into a raging bear market, these are among the first people we hear from—they are worried that their growth (what exactly did they think “growth” meant?) portfolios are down “so much.” Forget trying to explain that they are not down nearly as much as the market, or even to remind them that they had made this decision against all better judgment. These are among the first people who want OUT immediately and who say that they will get back in when “things settle down.”
This occurred with a client I will call “Jane,” who retired from working full time four years ago at the age of 58. At the time, she had a pile of money and I advised taking a less risky approach to her portfolio, because she could—meaning that because she had done the hard work of accumulating $4,000,000, she did not have to go beyond being a balanced investor over the next thirty years or so. After the first year, she came in for a meeting with one goal in mind: she wanted to earn more on her investment account so that she could stop working part-time. She recounted how friends of hers were doing much better with their money and that she wanted in on the action. She pushed all of the warnings aside, quit her job, increased the risk and then when the September massacre occurred, she pulled out of everything—completely!
The moral of this column is not to make people feel bad about losing money in the markets—we are all in the same boat on that front. Rather this is an important reminder that the decisions we make in our lives can often be the difference between being able to weather the storm and enjoying a good night sleep and succumbing to emotions and making another set of bad decisions. That is perhaps the silver lining for those of us in the advice-giving business…maybe this current cycle of lessons will finally help shift behavior in the future and prompt people to make more prudent financial decisions in our next phase.
Monday, June 30, 2008
Risk Taking
To close out a positively awful month for stocks (we are on pace for the worst June since 1930!), I thought that a fitting topic would be risk. The loose definition of risk as it pertains to investors is the chance that your portfolio will perform other than expected.
As we all know, assuming more risk increases your chance of BOTH making and losing more money. Still, it has been amazing to see the types of risk to which investors continually subject themselves. I have often ended a conversation with a radio caller, thinking to myself, “I just could not sleep at night if (that were my portfolio) or (if I had that much debt).”
What makes us assume those awful risks and why aren’t human beings better at keeping themselves out of trouble? The answer to this question can be found in the fascinating field of behavioral economics. Behavioral economics applies scientific research on human and social cognitive and emotional patterns to better understand economic decisions and how they affect market prices, returns and the allocation of resources. In other words, behavioral economics combines psychology and economics.
The basis for behavioral economics is Prospect Theory, which was developed by Daniel Kahneman and Amos Tversky in 1979 (Kahneman went on to win a Nobel Prize for this and other similar work) to explain how people make trade-offs that involve risk. These two shocked economists when they challenged the notion that long-held economic view that humans made rational choices based on logical calculations.
Hang on to your hats, but here is the earth-shattering conclusion: real people are not always rational! Through a series of experiments, the two economists attempted to disprove Utility Theory, which maintains that people make trade-offs based on a straightforward calculation of the relative outcome. Some people prefer sure things and others prefer to take chances, but whether the outcome is a gain or a loss doesn't affect the mathematics and therefore shouldn't affect the results. But Kahneman and Tversky found that people have subjective values for gains and losses.
All things being equal, we tend to be risk-adverse when it comes to gains and risk-seeking when it comes to losses. In case after case, the test results proved that humans accept small gains rather than risk them for larger ones, and to risk larger losses rather than accept smaller losses.
This may be why so many investors shoot themselves in the foot when markets move to the extreme highs and lows of a cycle. And of course, Prospect Theory affects ordinary as well as professional investors. The difference is that most pros recognize this fact and abide by some system to override the natural inclination to screw up the reasoning. I have always believed that the hardest part of investing is not the analysis of the economy or even determining which assets to buy; rather it is avoiding the emotional traps into which we all fall prey --- those are the biggest challenges we face.
As we all know, assuming more risk increases your chance of BOTH making and losing more money. Still, it has been amazing to see the types of risk to which investors continually subject themselves. I have often ended a conversation with a radio caller, thinking to myself, “I just could not sleep at night if (that were my portfolio) or (if I had that much debt).”
What makes us assume those awful risks and why aren’t human beings better at keeping themselves out of trouble? The answer to this question can be found in the fascinating field of behavioral economics. Behavioral economics applies scientific research on human and social cognitive and emotional patterns to better understand economic decisions and how they affect market prices, returns and the allocation of resources. In other words, behavioral economics combines psychology and economics.
The basis for behavioral economics is Prospect Theory, which was developed by Daniel Kahneman and Amos Tversky in 1979 (Kahneman went on to win a Nobel Prize for this and other similar work) to explain how people make trade-offs that involve risk. These two shocked economists when they challenged the notion that long-held economic view that humans made rational choices based on logical calculations.
Hang on to your hats, but here is the earth-shattering conclusion: real people are not always rational! Through a series of experiments, the two economists attempted to disprove Utility Theory, which maintains that people make trade-offs based on a straightforward calculation of the relative outcome. Some people prefer sure things and others prefer to take chances, but whether the outcome is a gain or a loss doesn't affect the mathematics and therefore shouldn't affect the results. But Kahneman and Tversky found that people have subjective values for gains and losses.
All things being equal, we tend to be risk-adverse when it comes to gains and risk-seeking when it comes to losses. In case after case, the test results proved that humans accept small gains rather than risk them for larger ones, and to risk larger losses rather than accept smaller losses.
This may be why so many investors shoot themselves in the foot when markets move to the extreme highs and lows of a cycle. And of course, Prospect Theory affects ordinary as well as professional investors. The difference is that most pros recognize this fact and abide by some system to override the natural inclination to screw up the reasoning. I have always believed that the hardest part of investing is not the analysis of the economy or even determining which assets to buy; rather it is avoiding the emotional traps into which we all fall prey --- those are the biggest challenges we face.
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