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Chalk Talk: August 2015

“It’s not what you don’t know that gets you in trouble. It’s what you know for certain that just ain’t so.”

– Mark Twain

We’re big believers in the notion that avoiding bad behavior will dictate long term investing success,and that managing behavior during volatile periods can be at once the biggest challenge and the most impactful of all the activities we conduct as financial advisors. This task has gone from theory to practice. The recent market downturn has reminded investors that stocks don’t go up in a straight line and that enduring short-term volatility is the price we pay for long-term returns.

Prospect Theory

Daniel Kahneman is a Nobel Prize winning behavioral economist that has written extensively on the subject, and we highly recommend his best-selling most recent work, “Thinking, Fast and Slow”. In it, he discusses the psychology of human decision-making, including a behavior known as “Prospect Theory”.

Basically, the theory states that we feel twice as badly about a loss as we feel positive about an equivalent gain. In other words, most of us dislike losing more than we enjoy winning! History tells us that on average, equity markets advance about 54% of the time on a daily basis, and fall about 46% of the time. On an annual basis, equity markets advance about 73% of the time, as opposed to the 27% of losing years. So the longer the time period we use for reference, the lower the frequency of losses that we will observe, and the greater the likelihood that we will not be tempted to let our emotions get the best of us and make poor choices.

So by that reasoning, if we are in the habit of checking the markets or our account values every day or week, we are almost guaranteed disappointment because of the way our brains are wired. The more often you check the “stats”, in theory the less happy you’ll be (and also taking time away from living and enjoying your life).

A Real Life Illustration

As you can see from this chart below, since 1980, top-to-bottom declines in the S&P 500 index during an average year have averaged 14.2%, even while returns have been positive in 27 out of 35 of those years. The red dots correspond to the top to bottom market decline, and the corresponding gray bar shows the total S&P 500 price return for the year.

Annual returns and intra-year declines

Image source: J.P. Morgan Asset Management

What this illustrates is how often we have to stomach downturns in order to capture the market’s upside. It also reinforces the point that if we have confidence in the long term uptrend in equity markets, then we should be more inclined to turn off the financial news and not bother checking stock or fund prices as often. For many of us, this is much easier said than done. Yet if we think back to prospect theory, which tells us that we tend to view a loss twice as painful as the positive feelings associated with an equivalent gain – then it’s easier to see why people have such difficulty sticking with a plan when they are observing (temporary) losses.

In one very real way, it’s unfortunate that the combination of advances in technology and the commercialization of financial media have created the temptation for us to feel compelled to be constantly checking and monitoring for signs of danger in the markets and economy. But just keep in mind that business of financial media is just that, a business that requires daily consumption of lots of trivial information in order to sustain itself.

If we can turn off the financial and economic news spigot (or at least be self-aware enough to realize its lack of significance over an investing time horizon), then we stand a much better chance of sticking with a solid financial plan over our lifetimes.

As always, thank you for your trust and confidence in us. Your feedback is always welcome.

Michael Traynor CFA®

Chief Investment Officer