The Investment Scientist

How to make bear market experience less unpleasant

Posted on: September 8, 2008

“Ignorance is bliss” – American proverb

In 2002, Daniel Kahneman, an Israeli-American, won the Nobel Prize in Economics for his ground-breaking work in behavioral finance. During last prolonged bear market, the Israeli Pension Authority came to him with an all too common problem. Pensioners kept changing their investment allocations according to prevailing market conditions. These frequent changes not only were unhelpful for the long term, but also added costs to pension management. Kahneman gave them one simple solution: send the pensioners statements quarterly instead of monthly.

How can it help to know less about your investment performance?

I studied all seven bear markets since 1970 and calculated their peak-to-trough drawdowns (a reduction in account equity) from the perspective of four different types of investors:

  • A: Investors who check their accounts intra-daily
  • B: Investors who check their accounts monthly
  • C: Investors who check their accounts quarterly
  • D: Investors who check their accounts annually

Here are the results:

    S&P 500 Peak to trough drawdown
    Peak date Peak Trough date Trough A B C D
    3/24/2000 1552.87 10/9/2002 768.63 -51% -46% -46% -40%
    7/17/1998 1190.58 10/8/1998 923.32 -22% -10% -10% 0%
    7/16/1990 369.78 10/17/1990 294.54 -20% -15% -15% -7%
    8/25/1987 337.89 12/4/1987 221.24 -35% -30% -23% 0%
    11/28/1980 141.96 8/12/1982 102.2 -28% -24% -19% -10%
    9/21/1976 108.72 3/6/1978 86.45 -20% -17% -15% -12%
    1/5/1973 121.74 10/3/1974 60.96 -50% -46% -46% -42%

Two observations emerge from this study:

  1. Regardless of the cyclic nature of bull and bear markets, the S&P 500 index keeps marching upward. (You don’t want to stop that march!)
  2. The more frequently you check your accounts, the more painfully you feel (and probably will react to) a bear market.

Take the bear market in 1987 for example; the intra-day peak-to-trough drawdown was 35%. For type C investors who checked their accounts quarterly, the drawdown was only 23%. Type D investors who checked their accounts annually would not feel the pain at all since the bear market began and ended within the year. Who would be more likely to stay the course? Go figure!

The author is president of MZ Capital, a RIA serving DC/MD/VA.  Get his monthly newsletter in your mailbox or get to the directory of his past articles.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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