Posts Tagged ‘behavioral finance’
This list is taken from an Irish Times article on behavioral economics.
1. LOSS AVERSION
People are more motivated by fear of a loss than hope of a gain, hence are more likely to seek to avoid a penalty than seek to gain bonus, even if both amount to the same thing.
2. ILLUSION OF CONTROL
For example, people feel an illusion of control when they’re allowed pick their own lottery numbers, even though they are no more likely to win by being given this choice.
3. DENOMINATION EFFECT
The tendency to spend more money when it’s denominated in small amounts (like coins) as opposed to large amounts (like large notes).
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My friend Carl Richards made an interesting observation in his last post:
Just when we need something to zig, they all zagged together!
Some people draw the conclusion that diversification no longer works. I strongly disagree.
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“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:
- 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!)
- 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.
The Investment Scientist 