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Don’t Buy Into the Fear: Equities are NOT Dead

I recently penned a rather gloomy outlook for Q3 earnings, which prompted a number of conversations and e-mail exchanges regarding my outlook. It appears contradictory to some that despite my short-term fears about an earnings slowdown or a bad few months for the market that I remain fully invested.

Well, let me explain why in one simple sentence: Because I am in my 30s and take a decidedly long-term outlook on stocks rather than try to time the market.

That’s not to say I don’t strategically focus on sectors or asset classes based on how defensive I want to get. However, study after study proves that risk aversion is counterproductive when it forces investors out of the markets altogether.

Take this study on market timing from Savant Capital. You may scoff at the period, since it only runs through 2007 and ignores the depths of the recent downturn, and also cherry-picks the best days to omit from the total… but I believe it’s still very instructive if imperfect.

The bottom line is that it’s easy to talk about the benefits of market timing when you can clearly see the biggest downturns in hindsight… however, spotting them in the future can be incredibly difficult — and bailing out of a market mid-rally can do as much harm to your portfolio as staying invested during a downdraft.

(As a side note: It’s also nifty that poor market timers from 1974 to 2007 STILL beat out Treasuries handily. So much for the “safety” of U.S. government debt.)

For a practical example, consider all the talk in the last few years about “lost decade” for stocks that cherry-picks the 1999 to 2009 period.

Yes, the 1999-2009 period was bad – due in part to two asset bubbles in the dot-com crash and then the housing/financial crisis. But this period is the exception, not the rule.

Take this from the research from Dan Wiener, editor of The Independent Adviser for Vanguard Investors, looking at every 10-year chunk of returns starting in 1986 (when Vanguard first started pioneering low-cost index funds):

  • The worst 10-year return for U.S. stocks was -2.6% for the period from 2/99-2/09 (the bottom of the bear market).
  • The worst 10-year return for foreign stocks was -0.3% for the same period.
  • How many 10-year periods saw negative 10-year returns for U.S. stocks? 16, or 8.5% of all periods measured. And all of those negative 10-year returns occurred over periods ending between Nov. 2008 and Aug. 2010.
  • How many 10-year periods saw negative 10-year returns for foreign stocks? 1! Yes, just one.
  • On average, over the 189 periods measured,U.S.stocks produced an average annualized return of 9.1%. Foreign stocks produced an average annualized return of 5.4%.

So why all the gloom and doom if history isn’t on the side of the long-term bears?

Well, you could argue that this isn’t your conventional bear market and that this time will be different. The best part about that argument is that it is difficult to prove wrong, at least until we have the benefit of another decade or so of returns.

But a simpler explanation has nothing to do with macroeconomics, but rather with psychology.

In 1963, MIT economics professor Paul Samuelson wrote a paper describing a bet he’d offered to a friend: a $200 gain for winning a coin flip vs. a $100 loss for guessing wrong. The refusal to take up that bet led to the general observation (validated in subsequent research  that our losses hurt twice as much as our gains – something most investors would agree with, since our dumb calls live on much longer in our memories than our winners.

In a similar 1999 study of risk aversion, academics Shlomo Benartzi and Richard Thaler offered a similar proposition – but this time focusing on probabilities by offering 100 coin flips for the $200 gain vs. $100 loss scenario. Anyone with a decent understanding of statistics should know that given 100 coin flips, the odds are remarkably in your favor that you will come out ahead… but about half of most normal folks were afraid to take the bet because the fear of losses were too much to overcome.

In short, we feel the losses greater than we feel the gains – and our fear of losses often keep us from making high-probability investments that could deliver high rewards.

We are hard-wired to be averse to risk, particularly when it comes to losing money. And when you see a steady drumbeat of bad news emerge about China, Europe and the Middle East– to say nothing of our economic struggles at home – it’s easy to buy into the argument that the stock market is doomed.

But while investing is never a sure thing, investor psychology is remarkably predictable. And all the research proves that investors err on the side of limiting losses above all else – even if that means sitting out an impressive rally as a result.

There are no guarantees we will see a roaring bull market in 2013. And the financial crisis and current troubles in Europe and China are hardly run-of-the-mill macro troubles that will pass easily.

But this kind of research is certainly food for thought — especially considering the gloominess of many investors in 2012 despite a double-digit rally for all the major indices.

Hopefully you’re not one of those investors who was still feeling the pain of their 2008 losses and missed out on this run as a result of aversion to the market in 2012. But if  you did… well, you just proved my point.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP

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