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Chalk Talk: January 2016

“When humans estimate the likelihood or frequency of an event, we make that judgement based not on how often the event has actually occurred, but on how vivid the past examples are.”

– Benjamin Graham

As 2016 kicks off, no doubt you have been barraged with the big headlines, highlighting a 6% first week decline in the S&P 500, which is over 10% below the May 2015 highs, while many prognosticators are calling for further carnage in the markets. Here are two facts to consider in this context:

1. The S&P 500 total return has been up in 12 of the last 13 years

2. Since 1946, the S&P 500 price has declined more than 10% during the year 55 times (almost once per year on average)

There are voices of reason out there in the media that unfortunately seem few and far between, but we encourage you to seek those out (and we try to highlight some of them every week in our “Top Plays of the Week“).

One of the most common investing mistakes stems from a cognitive bias that we all have, known as the “recency effect”. This simply means that we tend to take the most recent set of events and extrapolate them into the future, while placing far less emphasis on longer term trends and evidence.  Our brains are hard-wired to do this, and it takes constant and deliberate rationalization to avoid succumbing to these and other kinds of behavioral biases.

The impact of the recency effect is pretty clear. Investors, even professionals, tend to chase returns and follow herb behavior.  The headlines of the day seem far more important than they actually are in the context of any time horizon that is measured in years, not days or weeks.

Below is a chart that we came across that demonstrates the impact of our biases when combined with the media’s unrelenting exploitation of them. This is an admittedly unscientific study of the instances during the past several years in which CNBC aired its special “Markets in Turmoil” report, of course all during times in which markets had declined sharply in a very brief period of time.  But clearly it would not be a good idea to take action based on the advice of these panic-sayers during what amounts to completely normal market activity.

Markets in Turmoil

Markets in Turmoil

Image source: www.sentimentrader.com

And that’s the real point. When stocks fall multiple percentage points in the space of a few days or weeks, it doesn’t feel normal, even though the analytical part of our brain should know that it would be abnormal if it didn’t happen on a somewhat regular basis.  When volatility appears in markets, it doesn’t necessarily mean that something is off kilter or there is danger ahead.  We should remind ourselves that the presence of volatility does not necessarily signal risk; rather, this volatility is what creates the basis of future returns.  And for those of us that require our capital to outpace inflation over time, we have to remember that the price of admission is to accept market fluctuations and resist urges to do exactly the wrong thing because we have convinced ourselves that a recent downturn is destined to turn into a permanent crash and loss of principal.

The confluence of factors that drive day to day asset prices up or down are far too numerous, complex, and utterly unpredictable. The hubris or naiveté that is required of anyone who truly believes they can consistently and profitably predict short term price swings in the capital markets is astonishing!  But if you so choose, you can listen to or read their banter every day.  As you know, we strongly advise against it, in part because we understand that we all have an innate desire to believe that someone out there has the ability to know the unknowable.

There is, however, strong evidence showing that over longer time periods, owning stocks is one of the surest ways to preserve and grow real (inflation adjusted) capital. We know that what makes this so difficult to actually achieve is the challenge of staying rational and unemotional during more stressful times.  Controlling emotions is the hands down hardest part of investing.  Remember the plan, it’s there for a reason, which is to help us deal with the inevitability of routine and normal down markets.

As Ben Carlson (one of the voices of reason) recently said, “Most people advise you to stay the course during volatile markets.  This only works if you actually have a course to begin with”.

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

Michael Traynor CFA®

Chief Investment Officer