Monday, 22 June 2009

Learn from the Worst: Our Emotions - Need for an Emotional Rescue

If we don't succeed at it, why do we keep trying to time the market? Given the short-term unpredictability of the stock market, it's pretty much inevitable that we'll fail if we try to time our participation in stocks, yet we always think we can learn to do it.
  • "Man, it was so obvious that I should have done last time; now that I've learned my lesson, I'll be able to time things right next time." We tell ourseleves, even though it wasn't obvious what we should have done last time, and it won't be obvious whenit comes to future market-timing decisions (hindsight bias).

  • "And time and time again, when one of our stocks starts declining, we jump off of it and onto the latest "hot" stock, only to watch our old stock rise and our new, flashy stock fall."

Our emotions

We are emotional creatures, and in many cases throughout life, that's a good thing. When we are in danger, for example, we feel fear, and our brains interpret this feeling as a signal to flee for safety's sake.

In the stock market, however, emotion is one of our greatest enemies. Our intstincts tell us to flee when we see danger, and danger is what we see when our investments start losing value -

  • danger of losing our money,
  • danger of not being able to afford to send our children to college,
  • danger of not being able to afford to retire when we want to retire.

And, just as with other dangers we perceive, our first reaction is to flee - or, in this case, sell.

Now, when it comes to being attacked by an animal or a mugger who is trying to hurt you, fleeing from harm is a good instinct to have. But in the stock market, fleeing can, in fact, lead to great harm. That's because the danger we often sense in the stock market is false danger.

Perfectly good stocks fluctuate over the short-term (there's typically a 40 to 50% difference between a stock's high and the low for the previous 12 months), and sometimes it's due to factors that have nothing to do with their real value. (Think of the example in which one company is negatively impacted when another company in its industry posts a bad earnings report.) Because of the array of factors that go into its day-to-day movements, we just can't predict what the market's or an individual stock's short-term fluctuations will be with any degree of accuracy.

Nevertheless, we still act on them, and a big reason is emotion.

Peter Lynch once explained this phenomenon in an interview.

  • "As the market starts going down, you say, 'Oh, it'll be fine."
  • Then "it starts going down more and people get laid off, a friend of yours loses their job or a company has 10,000 employees and they lay off 200. The other 9.800 people start to worry, or somebody says their house price just went down. These are little thoughts that start to creep to the front of your brain."
  • People even start thinking about past financial disasters, bringing thoughts of such calamities as the Great Depression to the front of their minds, even if the current situation is nowhere near as bad.

In today's world of nonstop media hype and sensational headlines, it's very difficult to keep those thoughts from entering our minds. And the more they do, the more likely we are to make bad investment decisions.

Dallbar's study of investor behaviour shows that the percentage of investors who correctly predict the direction of the market is much lower during down markets than it is during rising markets.

During falling markets, when people have already been losing money, the fear of losing even more can cause many to cash out, even if the downturn is just one of Wall Street's periodic short-term hiccups. (Behavioural finance referes to this a myopic loss aversion.) Often, investors are then slow to jump back in when the market turns around, so they miss out on the bounce-back gains.

And it's important to remember that the market does bounce back, even when your fears and worries are telling you that "this time is different, this time the market won't recover." In fact, over time, the market climbs higher than any other investment vehicles.

According to reserach performed by Roger Ibbotson, Rex Sinquefield, and Ibbotson Associates, in the 20-year period that ended at the end of 2006, the S&P averaged an 11.8% annual compound return, beating long-term corporate bonds (8.6%), long-term government bonds (8.6%), and Treasury bills (4.5%).

While unpredictable in the short term, the performance of the stock market becomes quite predictable - and predictably good - when looked at over the long term.

Imagine, for a moment, that the market is a helium-filled balloon that you set loose outside on a gusty day. From moment to moment, it's hard to tell where the balloon is headed. It gets pushed around from side to side by the wind - that is, earnings reports, economic data, analysts' ratings, pundits' predictions - and sometimes even gets knocked downward. From moment to moment, you'd be foolish to bet someone exactly which way the balloon will go, since there's no way predict which way the wind will blow. But it's almost a sure bet that, over a longer period of time, it will end up a lot higher than it started.

In his book Stocks for the Long Run, Jeremy Seigel states that the market has averaged an annual compound return of 11.2% in the period 1946 to 2006. Siegel also examines those returns for their standard deviations. This is a statistical measure to show the rangee of returns in a "normal" year during a particular period.

If a stock has returned an average of 10% annually over a particular period with a standard deviation of 5%, for example, that means that about 2/3 rds of the time, its returns have been between 5% (the average return minus the standard deviation) and 15% (the average plus the standard deviation).

According to Siegel, the annual standard deviation of the market has been about 17% in the 1946 - 2006 period, which means that about 2/3rds of the time during the 60-year time frame, returns were between -5.8% and 28.2% , a huge potential year-to-year difference. (And that's the range returns fell into about 2/3 rd of the time; in other years they were even further from the average.)

The fact that such major year-to-year fluctuations can - and many times do - occur in the stock market makes for a lot of anxious times in the short term, but that anxiety is simply the price you pay for the excellent long-term returns that the stock market gives you. If stocks earned 10 or 12 % per year and were a smooth ride, why would anyone ever invest in anything else? This concept is known as the equity risk premium.

The bottom line: There are no free lunches in the stock market. If you want the long-term benefits of stocks, you've got to pay the price of short-term discomfort.

Ref: The Guru Investor by John P. Reese

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