The Investment Scientist

Posts Tagged ‘daniel kahneman

In January 2008, I wrote in my article “Recession and stock market performance” that:

Small cap value stocks are likely to outperform.

With one week left in 2008, the Russell 2000 Value Index, representing small-cap value stocks, has lost 34%. This is bad, but not as bad as the S&P 500 Index’s 41% loss and the Nasdaq 100’s 43% loss this year. The S&P 500 Index represents the largest 500 stocks in the U.S. and the Nasdaq 100 represents the largest 100 growth stocks.

Since January, I’ve heard pundits recommending large-cap stocks, tech stocks, pharmaceutical stocks, etc. Never once have I heard them recommend small-cap value stocks, which they claim are the most vulnerable in a recession.

Do I have a better crystal ball?

No, I don’t. I simply know the odds. As I wrote in “Small-cap value underperforming: a historical perspective,” the odds that small-cap stocks will outperform large-cap growth stocks on aggregate in any given year is 75%. So I can make the same “prediction” year after year and still be right about 75% of the time.

Why do most investors shun small-cap value?

According to Daniel Kahneman, father of behavioral economics, certain types of information are more accessible than others to the human mind. For instance, the concept of probability is not intuitively accessible, but descriptive words like “small,” “large,” “value” and “growth” leave instant impressions on our minds.

Another discovery of Kahneman is that humans take mental shortcuts in decision making. Confronted with the choice between large-cap growth and small-cap value, most investors eschew the hard route of calculating odds. Instead, they rely on their intuition that “large” is safer than “small” and “growth” has more potential than “value.” Thus, they “decide” to shun small-cap value stocks.

Small-cap value premium

An undesirable job has to pay more to attract job-seekers. Likewise, a shunned asset class commands a higher expected return in equilibrium. As long as small-cap value is not an intuitively attractive asset class, this return premium will continue.

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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:

  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.


Author

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

Twitter: @mzhuang

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