Market Commentary - 10.27.14
Losing Hurts More Than Winning Can Offset
Quietly, the S&P 500 posted its best weekly gain in nearly two years. Although the news headlines for the week looked promising as corporations posted solid earnings, investors still feel the pain from earlier in the month when the S&P 500 was down over 5.5%.
This phenomenon, where the pain of loss is greater than the joy of gain can be attributed to a stronger preference for avoiding losses, which leads investors to be willing to give up more potential upside in order to protect themselves against the downside. This phenomenon can actually be attributed to human psychology and is very common. In the finance world this is known as loss aversion and was first demonstrated by two psychologists Amos Tversky and Daniel Kahneman, the latter won the Nobel Prize in Economics for this research.
Examining a portfolio's performance more frequently increases the chance of seeing a loss, which can produce more emotional distress than comparable gains may satisfy. As an example, if an investor left on a tour of the rainforest on September 30th without any connection to the world and returned this weekend, he could check the S&P 500 ending value and shrug his shoulders to a 0.39% loss on a month to date basis with far less anxiety than his brother who had been going home after work every night and checking his account values go up and down with the market swings.
Checking a portfolio's performance or account values more frequently can cause investors to stomach far less exposure to more volatile assets. Experiments have been done that demonstrate the impact that frequent portfolio evaluation has on long-term asset allocation decisions. One study showed that a test group that made asset allocations decisions on a monthly basis allocated far less to equities than the test group that made allocations decisions on an annual basis. The first group allocated roughly 40% to equities while the second group allocated nearly 70% to equities. The investors who got the most frequent feedback (and thus the most information) took the least risk and earned the least money.
This has important implications because it may lead investors to forget about longevity risk, the risk of outliving one's assets. Investors need to try to earn a target rate of return to pursue their financial goals. If one deviates from their long-term goals and long-term return targets, they are risking falling short of reaching their retirement goals. When markets pull back and investors are tempted to change their risk tolerance, it is imperative for them to ask themselves what has changed in their goals. Did their risk tolerance change? Did their time horizon change? Or are they simply changing their long-term goals because the market had a pullback? Asset classes that demonstrate more risk (volatility) have higher potential returns and are vital to helping create wealth, which may mitigate longevity risk.
We feel that the recent volatility may be a sign of things to come. We feel volatility is here to stay and diversification is more critical than ever. Diversification with non-correlated asset classes with similar return targets can reduce volatility and help keep return targets on track. We believe investors should stay invested and maintain their risk tolerances consistent with their long-term goals.
Monitoring portfolio performance is important but, as we are all human, one should also know their psychological tendencies. If inclined to view performance over shorter time periods, investors should also evaluate performance over longer time periods to create perspective and make informed decisions.
1. The Effect of Myopia Loss Aversion On Risk Taking: An Experimental Test (Richard H. Thaler, Amos Tversky, Daniel Kahneman and Alan Schwartz)
This information is compiled by Cetera Investment Management.
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