Look Out Below!
Updated: Oct 15, 2021
Times like these do not scare us out of the market. We’ve been here before and undoubtedly, we will see such volatility again.
In Thinking Fast and Slow, Daniel Kahneman describes an experiment assessing investors’ propensity for risk. Participants were given $20 and asked to decide whether or not to invest $1 each of 20 successive times. A coin was to be flipped each time and if it fell heads, the investor made money, but if tails, the investor lost. Every time the investor won, they got back $2.50 (a profit of $1.50 plus their original $1.00) and when they lost they lost their $1.00. It is in the best interest of the player to bet every single time. If heads are flipped half the time, the investor ends the game with $25.00. In fact, 87% of the time, the investor would do no worse than break-even and most often make money. Only 13% of the time would the investor lose money.
But instead of playing every time, investors would only continue to play 40% of the time after a tail showed and they lost money. Even though the odds did not change and they still had better odds of making money than losing money, 60% of the time they would not play after they lost money. It got worse as time went along. In the first five rounds, 70% of the investors played the next round. But as the rounds continued, the pain of losing that $1.00 when a tail was flipped made more and more investors stop playing.
It is only by examining the study from our vantage that we can see that the best strategy is to play 100% of the time. However, this is indicative of what happens in the real investment world. When the market declines, investors lose their nerve and want out rather than viewing it as an opportunity to buy low and sell high.
There have been a number of studies that show staying in the market during up and down times produces superior results to those managers who try to move in and out of the market.
Check the returns our clients have seen over the years. Fewer than five percent of money managers produce the returns our clients have seen. But there have been up years and down years. I understand the emotional response of many investors when so many so-called gurus are peddling bad news.
My favorite hypothetical stock illustration (it will never exist, of course) is a stock that on day one is $10/share and after 40 years will grow to $414/share (10% annualized compounded rate of return). If you are buying this stock at $1,000 a year, the best outcome would be for the stock to remain at $10 for 39 years and then in the last year zoom to $414. Doing this, I would have invested $40,000 over 40 years and see the stock end at a value of $1,616,000. But most investors would grow disgruntled with the stock that does not increase over those first 39 years. They would prefer a stock that zooms from $10 in the first year to $375 and then increases $1 per year for each of the following 39 years. What that would mean is their $40,000 investment would end at $289,814! Many investors would be happy with that return and be happy with the investment. What they would not realize is how much better they could have done with that investment that seemed for those first 39 years to be “doing nothing”.
These examples illustrate for me the emotional side of investing. Most investors know the way to make money is to buy low and sell high. But in reality, investors are reacting emotionally and buying high and selling low. They fall in love with certain stocks that have done well in past and may or may not do well in the future.
We like to buy those stocks that have longer-term prospects of growing over a number of years. But if the growth slows or stops, we want to move on to another stock that has better prospects. I like to buy low, when the news is saying the sky is falling and the market or the economy is in terrible shape and stocks are not a good investment. I believe the stock market is a perception market. When it believes that 2+2=5, many people will pay 4 ¾ all day long. When the market believes 2+2=3, they will sell at 3 ¼ all day long. I just want to buy at 3 ¼ and sell at 4 ¾. I want to keep playing each turn when the odds favor making money. I do not want to get scared out of the market when it has such potential to go on to greater highs. In the game I mentioned, I will continue to bet the $1 even if there are two tails in a row, even if there are three tails in a row, because I have calculated my odds and I trust the math.
The risk is being out of the market, not being in the market.
Article Written by
Mike Adams, President & Principal
Adams Financial Concepts LTD
1001 Fourth Ave, Suite 4330, Seattle WA 98011