The Investment Scientist

Market Tumble and Investor Psychology

Posted on: August 9, 2007

market tumble and fear

On July 17th, the S&P 500 reached its peak after breaking a string of records. In a two week time however, both the S&P 500 and the Nasdaq Composite have lost 7.7%. The index that represents smaller stocks suffered a bigger loss of more than 10%. Are you feeling any pain and anxiety? I know I am.

Before I talk about how I deal with the pain and anxiety arising out of the market tumble, I’d like to first talk about the Equity Premium Puzzle and the Myopic Loss Aversion. These are weighty academic terms, but they would help us understand our psychology and how it could drive us to do stupid things.

Let’s suppose that John Doe has a 10 year investment horizon. He has $100k to invest. Should he invest in treasury bonds yielding 5% a year or in a S&P 500 index fund with long term average return of about 11%? If the money is invested in treasury bonds, 10 years later, John Doe will have $163k for sure unless the US government goes bankrupt. If the money is invested in the S&P 500 index, then John Doe can expect to have $284k. However, this is not sure money. He could end up with more or he could end up with less. The volatility of the S&P 500 is about 15% a year, so with 95% probability, John Doe’s money will be between $189k and $379k. There is a less than 2% probability that investing in treasury bonds will yield more in 10 years. If John Doe is rational, he should invest his money in a S&P 500 index fund.

What economists found out however is that the average John Does in America invest more of their money in treasury bond type fixed income securities. The economists call this the Equity Premium Puzzle, which can loosely be translated into “why on earth would any rational person look past the much better stock return to invest in bonds?”

The term Equity Premium Puzzle was coined in 1985. In 2002, psychologist Daniel Kahneman won the Nobel Prize in economics for his Prospect Theory which was developed decades earlier. Prospect Theory is a theory of how humans perceive gains and losses and how human decisions are driven by these perceptions. What Kahneman found was that the pain from losses is much stronger than the joy from gains of the same magnitude. For instance, when a baby is born, no doubt it is a joyful moment for the parents; but when a baby dies, the anguish felt by the parents is much stronger than the joy of birth. For another example, if you make $1000 in the stock market, you will be happy and excited; if you subsequently lose $1000, you will feel worse.

In 1995, Shlomo Benartzi and Richar Thaler used the Prospect Theory to explain the Equity Premium Puzzle. Here is my interpretation of their work. Regardless of his investment horizon, John Doe’s perception is instantaneous. An immediate gain in the stock market (which may not last) will elicit instantaneous joy and an immediate loss (which may not persist) will elicit instantaneous pain that is stronger than the joy. John Doe may be aware that over the long run, he will be ahead with stocks, but that long run result is unlikely to be in his mind. What is likely in his mind is the fear of the pain of losses he might suffer today or tomorrow. This fear is called Myopic Loss Aversion and it drives our investment decisions. For instance in the last two weeks, the 10 year treasury yield has dropped to 4.75% and blue chip stocks have fallen less than the broader market. These are evidences that people are rotating into bonds and blue chips out of the fear.

Do we want our investment decisions to be driven by fear? How do we harness the fear and even turn it to our advantage? Warren Buffet once said:” Be greedy when others are fearful, and fearful when others are greedy.” Daniel Kahneman also suggested that we looked at our investments quarterly instead of monthly. It would serve us well remembering their wisdom.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.

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