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Halloween is here, but many parents already had their scary moment in the middle of October. Over a period of less than a week, the market gyrated wildly. But we all know that the stock market has its ups and downs, so what exactly are investors scared about?
For the sake of brevity, we'll focus on two fears: Fear of loss and fear of regret.
Myopic loss aversion
There is plenty of experimental evidence that suggests that we want to avoid losses in our portfolio more than we want gains. Nobel-prize winners Daniel Kahneman and Amos Tversky showed that this aversion to loss means that people feel the fear of losses twice as much as the pleasure of the same amount of gains. Investors also tend to evaluate investments frequently and over relatively short time horizons. The combination of these two effects – Kahneman and others call this "myopic loss aversion" – has a negative impact on investor decisions and portfolio returns.
A 1997 Berkley University experiment showed that the subjects with the most information had the worst returns in their simulated portfolios. This can also be seen in real life. Over the last 30 years the S&P 500 generated an average annual return of 12.6 per cent (before taxes, fees, etc. are considered) with an annualized risk (as measured by standard deviation) of 17.5 per cent. In comparison, the annualized risk of Government of Canada bonds is in the neighbourhood of 3 per cent. Simply put, higher returns mean higher risk.
However, if the S&P 500 Index portfolio discussed earlier was evaluated over a 5-year time period (the way Canadians typically approach their real estate holdings), it would have an average five-year rolling risk measure of 9.0 per cent over the same 30 year period. A similar portfolio evaluated over a 10-year time period would generate an average 10 year rolling risk measure of just 6.3 per cent.
So, evaluating stock market portfolios frequently and over short-time periods amplifies the risk that investors perceive in their portfolios. This "trick" drives the fear of loss.
So what can investors do to help manage this fear? The first is to bucket their money. People already do this for things like holidays, the mortgage, money for the kids' education and money for retirement. Take this one step further and actively invest your money for each bucket, taking into account when you will need it. Studies have shown that investors have different risk tolerances for different goals. If retirement is not for another twenty years, this approach will help reframe "short-term horizon" thinking to "long-term horizon" thinking. This "goals-based" approach to investing tends to better align with the way investors implicitly "frame" their portfolios.
Secondly, after putting a plan in place, investors should not react to every market movement and news report until their next annual portfolio review. Investors would be surprised to learn that over the last 34 years, the S&P 500 Index has had average declines of 14.7 per cent annually during the year; but the S&P 500 Index still finished positive for the year in 28 out of these 34 years. It is "normal" for stocks to fluctuate significantly but reacting to every such movement could be detrimental to an investor's wealth.
Fear of regret
Perhaps even more than the fear of loss, investors fear regret. Investors imagine going into a cocktail party and hearing from friends and neighbours about their great investment and not having a similar story to share. Researchers have shown that maximizers, those who want to always make the best decision possible, tend to have more regret than satisficers, those who set criteria and choose the first option that meets those criteria.
Investors who are maximizers look for the best investment returns, while satisficers have a minimum return in mind and are happy with any investment that meets that return and don't look further.
Market volatility often triggers the fear of regret as investors look at the potential loss on the portfolio versus "locking-in" gains now. There is some truth in the old joke that economists have predicted 10 out of the last 8 recessions. Pundits have been calling for a significant correction in the market since the beginning of January 2013. If investors had panicked and pulled out of the market at that point, they would have missed out on the almost 35 per cent gain that the S&P 500 Index had between January 2013 and the end of September 2014.
According to Santa Clara University professors Carrie Pan and Meir Statman, investors with a tendency to look back on past decisions and re-evaluate them based on current information – those more likely to be maximizers – are likely to have significant "regret". A maximizing investor who chose to invest conservatively after the 2008 crisis may experience regret today because of the gains they missed out on. A propensity for maximizing behaviour is not something that can be easily changed. However, it is often more practical and pragmatic to make a good choice than trying to make the best choice. Ultimately, to be successful in investing, an investor not only has to know their risk tolerance but also whether they are a maximizer or a satisficer and their likelihood to feel regret about past decisions. It may very well be the case that investors are satisficers with one goal and maximizers with other goals; here again, a goals-based approach to investing may help investors mitigate the fear of regret.
Warren Buffett's mentor, Benjamin Graham, famously said that "In the short run, the market is a voting machine but in the long run, it is a weighing machine." Fear of regret means that too often investors pay too much attention to the "voting machine". Setting goals and a plan to reach that goal, based on the best available information at hand, is the best way to maintain the discipline to avoid the voting machine.
Sam Sivarajan is head of investments with Manulife Private Wealth