Tag Archives: Behavioral Economics

Don’t Be Euphoric Over Two Months Of Gains

Stocks are up big this year, and that means it’s time to be skeptical.

Warren Buffett says you should be greedy when others are fearful and fearful when others are greedy. That doesn’t mean stocks are ready to give up all their January and February gains immediately or even eventually. But it means the right psychological disposition to have is one of doubt and skepticism. If we get the decline, you’ll be ready for it. And being ready for declines, so that they don’t surprise you and cause you to sell, is the most important thing in investing.

Here are the numbers. Domestic and foreign stock are all up between 9% and 12% for the opening two months of the year. Mid-caps and small-caps are up even more, with the Russell 2000 up an eye-watering 17%. Junk bonds are up more than 6% and REITs are up more than 12%. Balanced indices are up between 7% and 8%, depending on whether they have foreign stocks or not.

It’s okay to be happy about this, but it’s also good to temper that happiness with some skepticism. Stocks don’t usually go up this much in two months. In fact, they don’t usually go up this much in a year. If you’re thinking that the current move is justified because of how much stocks declined in the last quarter of 2018, you still may be fooling yourself with too much optimism. Stocks have been up like gangbusters for the past decade. (Incidentally, if you panicked at the end of last year, and sold, you know how prone  you are to make moves at the exact wrong moment.)

None of this means you should run for the hills and sell all your stocks in a fit of contrarianism. But it means you should temper your expectations. (And trimming some gains might not be a bad idea. Rebalancing, especially in a tax-advantaged account is reasonable after a run like this.) It’s just as likely that stocks could drop from here as it is that they could tread water or keep going up. Nobody knows.

The end of last year is instructive about trying to time short-term moves. At the end of last year, longer term moving averages indicated that there was more downside, while shorter term moving averages indicated that the markets were “oversold,” and that a least a few days of upside were in the cards. It turned out that when things looked bleakest, on Christmas Eve or quickly thereafter, the market bottomed, and stocks have been off to the races ever since.

In other words, both the long term indicators and the short term indicators from the end of last year look foolish right now. We didn’t get a few days’ worth of gains in response to being “oversold;” instead we’ve gotten eight solid weeks of boffo returns. That’s what the market does — it makes everything look foolish sometimes. Sure, stocks might decline from here, proving the longer term indicators from late last year correct. But these two months show how hard short term timing is. It’s possible to argue that U.S. Federal Reserve Chairman Powell indicating that the rate-hiking regime would end was a wild card at the end of last year. That’s true, but it doesn’t damage the thesis that short term trading is difficult.

Being successful in the stock market isn’t so much a function of what system you follow as much as it is a function of whether you can follow a system and whether you can keep your emotions in check. Every system – buy-and-hold, buy-and-rebalance, moving average – will look foolish at times. It will deliver losses or look lackluster when others are making gains. Take Bill Bernstein’s advice in this weekend’s Wall Street Journal, and consider your financial assets (stocks and bonds) as future assets and not present assets. In other words, “mentally vaporize 75% of your assets; imagine you don’t even have them.” That can help you get through market declines. You don’t own stocks to buy groceries tomorrow, after all. Remembering that, and having the right psychological disposition can make a big difference in helping you let financial assets work for you — instead of letting them work you over.

Volatility Is Back

After a bad week in early February when the S&P 500 Index dropped 10% to meet acknowledged definition of a correction, the market has rebounded and investors have mostly regained confidence. On Monday, March 5, the Index bounced over 1% higher making its year-to-date return over 2% — a perfectly respectable return in the early days of March.

However, one can’t help but have an uneasy feeling that it’s a different market environment in 2018 than it was in 2017 when, for the first time in history in one calendar year, the market posted positive gains in every month. Using the S&P 500 Price Index (not including dividends), The market was so anesthetized in 2017 that it posted only 8 days of gains greater than 1% or losses more severe than -1% from the previous day’s close. This year, the market has already posted 16 days of gains greater than 1% or losses more severe than -1% from the previous day’s close.

Moreover, the index experienced no one-day 2% gains or losses in 2017. It has already had three such days in 2018, all of them to the downside.

Another way to look at volatility is to measure the average daily volatility, using absolute value of daily changes. As our chart shows, over the roughly five year period from the start of 2013 through March 5, 2018, the S&P 500 Price Index moved an average of 0.54% on a daily basis. For 2017, that number shrank to 0.30%.

It’s also useful to look at standard deviation, a statistical measure that indicates the range of most, though not all, moves from an average. For the five year period, the standard deviation of the index was 0.77%, while for 2017 the standard deviation was 0.42%.

Lessons for Investors

Investors should learn from this graph that the low volatility of 2017 was unusual and that it’s not reasonable to expect that environment to persist. Investors should also take the opportunity to review their asset allocations. The fact that markets have rebounded since their declines in early February shouldn’t be so much cause for joy as an opportunity to reassess how much volatility is tolerable.

If an investor was unnerved by the market drop in early February, that likely means their allocation was inappropriate. Too many investors have piled into stocks because bond yields are low and long-term historical stock returns promise to make up the difference for under-saving for retirement. But century-long or longer stock returns mask the fact that stocks go through decade-long and two decade-long fallow periods, especially when valuations are as high as they are now.

Investors tend to forget how they feel during bear markets, especially when those bear markets are in the distant pass. We tend to have what behavioral finance professors call an “empathy gap” regarding our own feelings and behavior in stressful markets. But since early February isn’t that far away, investors should use it as an opportunity to reassess how a downturn might make them feel. If you wanted to sell stocks instead of stay put or buy them as prices got cheaper, it’s time to reassess your allocation – while you still can without having to change it after a decline.

Investors should also consider that bonds, though offering lower than normal historical yields, still have a place in portfolios. Their stabilizing influence is often most welcome when investors have written them off as boring next to stocks, their more exciting cousins. As other investors forget risk and unnerve their brokers and advisors with extreme bullishness, it might be a good time to be cognizant of just how much excitement you can tolerate. Investors feeling themselves capable of accepting more risk should also consider the words of investor Howard Marks, — “The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so, and risk compensation will disappear.”