When Markets Wobble, Don’t Look Down!

When market volatility spikes and the variance in returns starts to widen, people naturally start to worry. As recently as the fourth quarter of 2018, wild market swings wiped out the gains from the previous 9 months. As someone who records his net worth monthly, I know it certainly felt like a sucker-punch to see these gains eroded as I updated my year-end numbers. However, keeping a long-term perspective usually pays dividends.

Don't Look Down

That said, it is easier said than done. We are surrounded by daily commentary on the markets; which stocks, bonds or currencies went up or down that particular day for whatever reason, logical or otherwise. It’s really all just noise in the short-term, but the financial media sucks you in and gets you hooked on short-termism, blinding rational thinking. Paying too much attention results in panic, overreaction (or sometimes both!) rather than staying the course.

Thinking, Fast and Slow

One of my favourite books of recent years is ‘Thinking, Fast and Slow’, by Nobel Memorial Prize in Economic Sciences laureate Daniel Kahneman. The book is a summation of his decade long work in studying the way humans think. If you have not read it, I highly recommend it and its certainly one of the best books on behavioral science out there. I was lucky enough to see him speak a few years back at a packed-out event in London. It was highly engaging.

The main premise of this work is that we, as humans, subconsciously apply two different speeds of thought when processing information – Kahneman refers to these as systems. The somewhat imaginatively titled System 1 is fast and System 2 is slow – hence the ‘Thinking, Fast and Slow’ title.

System 1 allows us to respond quickly to external stimuli with limited information. In contrast, System 2 is more pensive and calculated. Each has their own benefits and also their drawbacks, but together they help to explain large parts of the cognitive biases that Kahneman, and collaborator Amos Tversky, document in the book.

An Investment Perspective

In many ways, we all owe System 1 an immense debt of gratitude as its largely got us here today. Without the ability to think quickly on our feet, often with limited information, we would not have advanced much as a species. While System 1 remains very useful to us, there are many modern-day scenarios where it can sometimes do more harm than good. Investing is very much of one of these scenarios.

After a fairly standard year in 2017, markets began to bite in 2018, particularly during that fourth quarter where a very high percentage of funds and ETFs, spanning multiple asset classes, experienced negative returns for the year. To see highly correlated returns to the downside, across almost all aspects of the market is a rare event. So, is it time to panic?

In such environments, with nowhere to run to and nowhere to hide, it’s important to always remain aware of how we are conditioned to respond to situations like this. Efforts should be placed on thinking of ways to avoid succumbing to our instinct to ‘think fast’ and react, rather than taking a longer-term view and ‘think slow’.

Short-Termism

One of the most seminal works from the field of behavioural finance examined how investors respond to, and demand to be compensated for, the risks that they undertake.

In the paper ‘Myopic Loss Aversion and the Equity Premium Puzzle’ authorsShlomo Benartzi and Richard Thaler introduced the concept of ‘myopic loss aversion’.

Myopic loss aversion is an attempt to combine two pre-existing bodies of research. The first one is the equity premium puzzle. It is a commonly held truth that over very long periods stocks have significantly outpaced bonds as an asset class. This is true of almost any geography. Of course, stocks should offer higher returns to investors than bonds because they are riskier, but its the magnitude of the outperformance profile that can be puzzling.   

The second body of work is loss aversion. Investors tend to feel more pain when they lose money than they do pleasure when they make money. As a result, they demand higher compensation for taking on risk. From an investment standpoint, loss aversion leads investors to check on their portfolios regularly, too regularly in fact.

Benartzi and Thaler went on to claim that these two effects can help solve the equity risk premium puzzle. They found that investors who checked their portfolios frequently, such as once a year (some may consider that infrequent!) – tended to behave as though they had a planning time horizon of one year, even though their intended time horizon might be decades away – i.e. planning for retirement.

But the odds of losing money in risky assets with positive expected returns, like stocks, actually declines over time. Benartzi and Thaler then argued that investors’ perception of risk actually increases as they check in on their portfolios more frequently. As a result, they demand a larger equity risk premiums to compensate for the greater variability of returns.

In the authors’ own words:

“The longer the investor intends to hold the asset, the more attractive the risky asset will appear, as long as the investment is not evaluated frequently.”

So the moral of the story is that the further we can remove ourselves from the inexplicable day-to-day swings of the markets, the less risky we perceive our investments to be. This, in theory anyway, should help us to stay the course when markets test us.

A Picture Is Worth a Thousand Words

Going back to Daniel Kahneman’s book, below I have included some figures to try and illustrate the potential value to thinking slow, instead of fast, especially over longer evaluation periods. This should help keep things in perspective.

All Equity Portfolio

The top row shows calendar-year returns for the MSCI World Price Index to a UK investor (in sterling terms) – I’ve chosen this a proxy for a well-diversified global equity portfolio. Subsequent rows show the annualised returns over the following two to 25 years. At the bottom of each column, I’ve added how much an initial £10k invested would have grown to, compounded over these different time frames. The grid is also colour coded to show different return profiles, from most positive (dark green) to most negative (dark red)

Pursue FIRE Equity

I personally find this a very interesting graphic. For example, take the 2008 credit crisis. The MSCI World Index declined 19.8% that year and this was certainly a time when people were panicking. It was hard not too, watching several large financial institutions flirt with, or succumb too, collapse or some form of government intervention (Lehman Brothers, RBS, Northern Rock etc).

However, the following year (2009) the MSCI World Index gained 13.1%, clawing back a meaningful chunk of the prior year decline. And 2010 then saw a similar 13% return. Had you stayed invested from the start of 2008, just six years later, your annualised rate of return was back up to a reasonable 3.9% per annum. Held on, a full decade later through to 2018, this had climbed to 5.8% per annum.

2011, in which the market declined 6.9% is another recent example. Within two more additional years to 2013, the annualised rate of return was back up to 7.0%, where it has largely remained over longer time-periods in recent years.

You have to go all the way back to the Tech bubble bursting to see some obvious pain. Years 2000 to 2002 were clearly a challenging period to be starting out as an equity investor. Often cited as the lost decade – investment at the start of 2001, for example, would have had a persistent negative annualised rate of return for 9 years, before breaking even again in the 10th year. But even then, roll on to the longer time periods and returns are positive (albeit on the weaker side of long-term return expectations).

A Balanced Portfolio Perspective

But all of this assumes you stayed 100% invested with a 100% allocation to an equity-like product. No doubt, investors would have explored alternative asset classes during these somewhat challenging periods.  

What about a more balanced view? The same grid is shown below but this time showing an equity biased portfolio (for long-term growth) blended with an exposure to global bonds to diversify risk and smooth out volatility. As before, the MSCI World Index is the equity bucket, weighted at 70% of the portfolio. For the bond exposure, the Barclays Global Aggregate Index is a great proxy for a globally diversified, investment grade bond portfolio, comprising government and corporate bonds. This is weighted at 30%. The weightings have been rebalanced on an annual basis. A 70/30 split like this is a very common method to combine equity and bonds in a balanced portfolio.

Pursue FIRE Balanced

The presence of bonds in this blend served to shave off the high points of volatility. Notice how returns quickly revert to a very reasonable rate across almost any starting point in the last 25 years.

Now clearly, it’s impossible to buy an index such as the MSCI World, but the popular choice among most FIRE proponents is to gain market exposure (or beta) via investing in passive tracker-style products.

While the chart above offers a long-term perspective, there are few investments today which stretch that far back. It’s still a very valuable picture and a lesson, that the noise tends to wash out over time and that returns are far more consistent the longer out you look – or less risky as Thaler suggested.

Vanguard LifeStrategy Perspective

While, a much shorter history than the MSCI World Index, one of my main investments of the last several years has been the Vanguard LifeStrategy 100% equity Fund. Here is the same chart again, based on the accumulation share class, net of fees in sterling terms. The fund only has 8 years under its belt (7 full calendar years), so it has yet to be really tested over multiple market cycles.

Pursue FIRE Vanguard

2018 was, in fact, the first negative year for the fund in 7 full years. So its certainly not time to think fast and panic! Having been invested from the start, the fund has delivered a time-weighted rate of return of 11% per annum. (money-weighted rates of return will vary based on the size and timing of individual contributions and withdrawasl)

This is a picture I follow with interest 😉

Further Reading

If the area of behavioral finance is of interest, I recommend the following video, in which Nobel laureates Eugene Fama and Richard Thaler discuss how markets behave (and misbehave). Along the way, they discuss value stocks versus growth stocks, the existence of economic bubbles, and the curious case of the CUBA Fund. It’s a great discussion between two of the brightest minds.

And here is the link to the Thaler & Benartzi paper referenced above for a heavier read 😉

‘Myopic Loss Aversion and the Equity Premium Puzzle’

Finally, if you wish to pick up a copy of Daniel Kahneman’s book, you can do so here via Amazon. (affiliate link)

I hope you enjoyed the article

Stay the course

Dan

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Hello and welcome to Pursue FIRE. My name is Dan and I am the owner and author of all content on this site. I am passionate about personal finance and look forward to engaging with you.
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