Archives For Investment Psychology & Stock Declines

Quiz!

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter.
  3. It was scarier.
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual.

The Surprises & The Expected of 2020

The pandemic of 2020 was shocking to investors and humans in general. It involved substantial uncertainty, leading people to predict years of pain for stock investments. While the split between surprises & the expected will vary depending on the reader, below is my split.

Surprises:

  1. While the key actions to contain the pandemic were known early on (looking at some Asian countries), the magnitude of unwillingness to take these actions seriously in other countries was greater than I expected, leading to a much worse result than possible otherwise. While stocks recovered rapidly, they could have bottomed higher, with fewer lives lost on the way.

Expected:

  1. The decline was shorter than typical, because it didn’t come from a position of economic leverage and euphoria.
  2. When panic took hold in March, the Fed repeated its 2008 announcement, being prepared to do whatever it would take to support the economy. Other countries operated similarly.
  3. The turnaround came as soon as the level of uncertainty diminished, far before the economy improved, as typical.
  4. While the economy is still hurting badly, it started the turnaround much earlier than in prior declines, thanks to the cause being a shock and not leverage.
  5. Many people said about this decline that it’s different, and will last much longer than past declines. Fortunately, this prediction failed, as typical when made at past times of uncertainty.

The specifics of every market decline are different, creating a need to prepare for declines of varying lengths & depths, worse than we experienced before. While the specifics vary, there are some truths that follow through the cycles, especially some level of correlation between starting valuations (e.g. Price/Book) of risky assets and the severity of the decline. With the right planning, whether cash set aside or low spending relative to liquid assets, there is no need to label any case as “this time is different”. The more prepared you are, the stronger you can be going through scary times, with discipline to avoid panic selling at the depth of the decline.

Quiz Answer:

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter. [Correct Answer]
  3. It was scarier. [Correct Answer]
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual. [Correct Answer]

Explanations:

  1. This decline was shallower than the other two declines.
  2. This decline was dramatically shorter than the other two declines.
  3. While every decline is scary, this was scarier, because we haven’t seen such a widespread pandemic in our lifetimes.
  4. This decline was dramatically shorter than the other two declines.
  5. In most declines, the turnaround comes far ahead of the economic turnaround. It comes from a combination of government & central banks (e.g. the Fed) support along with an expectation for a future turnaround.
  6. Both 2008 and 2020 saw very big government & central bank support, but this year’s support was even bigger.

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news.
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Testing Emerging Markets Value Investments in a Simple Graph

Value stocks are priced low relative to their intrinsic value (low Price/Book, or P/B). Value investing makes logical sense: when buying cheap stocks, you can expect to enjoy higher returns. It is not only logical, but also supported by nearly 100 years of evidence. This is all nice, until you look at the past 10 years and see that value underperformed growth (high Price/Book) for the whole period. This raises the suspicion of a new normal. Maybe the entire group of companies with low prices has something wrong with them, and their value will go down over time, to justify the low price?

There is an easy test to differentiate between bad companies and cheap investments:

  1. Bad companies: The underperformance is explained by underperformance of their book values relative to the rest of the market. This is why Warren Buffett tracks the book values of his companies more than prices.
  2. Cheap investment: A lot of the underperformance of value stocks is explained by a change in their valuations (P/B) relative to the rest of the market.

As an example, here is a comparison of DFA funds, one representing overall Emerging Markets (EM), and the other representing EM Value. The graph divides the valuations (P/B) of EM by EM Value. A high value represents an increase in the price paid for all of EM relative to the price paid for EM Value stocks.

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For the year (2020), EM Value underperformed EM by about 11%, while the valuations difference increased by 15%. This means that the value companies, as measured by their book value, did 4% better than the overall market. This supports the thesis that these investments are simply cheaper, and you may reap the benefit as the valuations continue their cycle.

Quiz Answer:

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news. [Correct Answer]
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Explanations:

  1. You cannot conclude anything positive or negative from a 1 year period.
  2. See #1 above.
  3. The combination of averaging many 10-year stretches with a focus on pricing (valuations) similar to today, gives useful information.
  4. See #3 above.
  5. After a decade of unusually good returns, the risk of a weaker decade goes up, so it is not necessarily a good sign.
  6. After a decade of unusually good returns, the risk of a weaker decade goes up, but it is also not a guarantee for a bad next decade.
Disclosures Including Backtested Performance Data

Quiz!

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

A Hidden Measure of Investment Risk, Beyond Volatility

This article debunks a conventional wisdom that equates volatility with risk, and ignores all other factors. The following example demonstrates a problem with this narrow focus. Compare the following two situations:

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

By focusing on volatility alone, you would conclude that the first investment is less risky. This conclusion is wrong. The lowest balance that the stable investment can reach is 1M, since it never declines. The lowest balance that the volatile investment can reach is 1.2M, since it starts with 3M and can go down by up to 60% of the peak. The first investment is riskier for two reasons: (1) it grows more slowly on average, and (2) it has a lower worst-case balance. Your risk of running out of money with this investment is greater.

Since the starting investment amounts are different in the two cases, how can this apply to the real world? An example could help:

  1. Say you have 1M invested in a stable investment.
  2. The investments grow to 1.1M through a combination of investment growth and new savings. This allows you to shift your investments towards higher expected growth along with higher volatility. Specifically, the investments can potentially decline by another 100k (10%) during declines, to get you to the prior risk during declines.
  3. You repeat the step above, leading to higher and higher expected growth, while keeping the risk level the same.
  4. Your investments reach 2.5M, and you reached an allocation for maximum potential growth, along with potential declines of up to 60%. Your risk level is still the same with the lowest balance being: 2.5M x (1 – 60%) = 1M.
  5. Your investments reach 3M, and you keep the allocation the same, since you already enjoy the maximum potential growth. But now the lowest your investments can reach is up to 3M x (1 – 60%) = 1.2M, giving you higher security, despite the much higher volatility.

Notes:

  1. Risk is determined by spending/investments, not investments alone. To account for expenses going up or down, you should track spending/investments, not just the investment balance.
  2. Another risk factor is the valuations (P/B = Price/Book, or price relative to intrinsic value or liquidation value). In diversified portfolios, high valuations lead to higher risk (greater potential decline), and lower valuations lead to lower risk (lower potential decline).
  3. Some stable investments are exposed to inflation risk, making them riskier than seems.  On the other hand, there is no guaranteed maximum decline for any investment.  It is all a matter of odds.
  4. If higher volatility leads you to panic and sell low, that is another risk factor that can take away the financial benefits described above.
  5. While income from work can be lost at any point, some jobs are much more secure than typical (e.g. doctors), and can help your risk profile.

Implications:

  1. A plan that may be risky for someone else, may be conservative for you (and vice-versa), depending on your respective ratios of expenses/investments & valuations.
  2. A plan that would have been risky for you a few years ago, may be conservative for you today (and the reverse is potentially true if your expenses grow faster than your investments).

Quiz Answer:

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines. [Correct Answer]
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

Explanation: See article for explanations.

Disclosures Including Backtested Performance Data

Quiz!

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy.
  3. When stock valuations are high, and uncertainty is high.

Investing in the Midst of a Pandemic

The coronavirus pandemic brings substantial uncertainties. While the instinct is to wait for clarity before investing, the biggest returns tend to come starting at times of greatest uncertainty. This was true in past declines, and the current one is no different. On 3/23/2020, stocks hit a bottom with no clarity on the timeline for the world stopping the spread of the virus, and no clarity on how the world economy would survive social distancing. A moderate reduction of uncertainties led to phenomenal gains in stocks. As additional uncertainties get resolved, there is a chance for additional gains. This article refers to the coronavirus – as always, additional negative and positive surprises may appear, leading for ups and downs, beyond the uncertainties listed below. In addition, investors expect economic pain from the social distancing, and this may be reflected in stock prices too little or too much. Here is the timeline so far and potentially looking forward.

Past:

  1. Around the bottom, central banks and governments announced substantial support for economies, including the Federal Reserve using the term “unlimited support”.
  2. Over time, we saw the number of daily new cases in many countries level off, and in some cases, revert. This gave some comfort that with social distancing, the virus could be contained in a reasonable timeline.

Future:

  1. Additional central bank & government support until the end of the pandemic’s economic impact.
  2. Increased testing, to allow quick isolation of infected people. A lot already happened, but more is needed.
  3. Increased contact tracing, both automated and manual, to isolate people who got in contact with infected people. Automated solutions are being developed. There is currently substantial hiring for contact tracers. My understanding is that a lot more progress is needed on this item. This is a good example of creating reemployment to help with the effort to end the pandemic.
  4. Transition from level and fewer daily new cases, to a worldwide reduction in total cases, so fewer people will be able to spread the disease.
  5. A potential die-off or weakening of the virus, as eventually happens with some viruses.
  6. Treatments to reduce the severity of the disease.
  7. Widespread vaccines.

Key Point: The intuition of many investors is to wait to invest in stocks until uncertainties are removed. This leads them to invest at times with much higher risk of long-lasting declines. If you have enough resources to weather substantial declines that are always a possibility with stock investing, you may be lucky enough to invest at a time that can both help your returns as well as prepare you for future cycles.

Quiz Answer:

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy. [Correct Answer]
  3. When stock valuations are high, and uncertainty is high.

Explanation:

  1. A strong economy with positive sentiment can lead to gains for a long while, but is also reflective of peaks in stocks.
  2. When the economy is in poor shape, and valuations already reached low levels, people already sold a lot. The declines may continue for some time, but eventually a turnaround comes, and some of the strongest stock returns may begin.
  3. High uncertainty along with high stock valuations could sometimes lead to gains and sometimes losses. The high valuations sometimes mean that not enough selling was done to reflect the uncertainty.

See article above for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.Disclosures Including Backtested Performance Data

Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the portfolio Extended-Term Component grew by a mere 2% per year in the past 10 years, compared to 9.3% 22-year average. In addition, the valuations of this portfolio are far below average. Returns above the 9.3% average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

High investment growth comes with volatility, and is treated as the price for enjoying the high long-term gains. What if you could stay happy even during declines?

Conditions:

  1. When working, live according to your income. Don’t spend beyond what you make.
  2. When retired, spend a small percentage of your portfolio every year. Don’t plan on running out of money in your lifetime. 3%-4% is appropriate for most diversified portfolios with a high enough stock allocation.
  3. Invest in a highly diversified stock portfolio, without any specific bets (specific companies, countries, etc.).
  4. Structure the portfolio for high growth (emphasize stocks, value investing, small stocks, fast growing countries).
  5. Maintain iron discipline to stick with your portfolio for life, and never make changes at low points (unless you move to another investment with at least equally low valuations and equally high long-term returns).

If you follow the conditions above, you can be happy in up and down times, as follows:

  1. By nature, you have a fast growing portfolio in the long run, a cause for underlying happiness.
  2. When you enjoyed high past gains, you can be happy with the past results.
  3. When recent returns have been poor and valuations (price/book) are low, you can be happy about the high expected returns.
  4. If you have any new money to invest (savings from work, inheritance, money elsewhere), you can be very happy, because investing this money at a low point turns a temporary decline into a permanent excess gain (the gains on buying low).
  5. Over the cycles, the dollar value of the percent spending can go up as you reach higher peaks, leading to happiness about growing cash flows.

Most people struggle with such a plan, because the media pushes them to think about parts of the cycle, e.g. 5-10 years. This leads investors to be unhappy during downturns, and sometimes even destroy their life’s savings by selling low and buying something else high. Any high-growth investments can go through downturns of 5-10 or more years (e.g. the S&P 500 lost 30% of its value in the 10 years from 3/1999-2/2009), so it takes strength to stay disciplined. The best tool to maintain discipline is to watch valuations (price/book). After your high-growth investment goes through a long tough stretch, you can compare it to another investment that performed very well in recent years, and you are likely to see that your investment is enjoying substantially lower valuations, leading to substantially higher expected returns in upcoming years. While there is no guarantee for a specific turning point, you enjoy the nice combination of lower risk and higher expected returns.

Quiz Answer:

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Explanations: None of the answers are correct!

  • 1-2 depend on concentrated investments. History taught us repeatedly that single companies aren’t immune to irreversible downturns.
  • 3-4 may feel good at the moment, but they turn a temporary downturn (assuming your investment is diversified and consistent) into a permanent loss.
  • 5 may also feel good at the moment, but investments are cyclical, and the best performer of the past 10 years is likely to underperform your poor performing investment in the next 10 years. A glance at the relative valuations (price/book) of the investments can confirm this risk.

Disclosures Including Backtested Performance Data

Quiz!

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that.
  2. He is wealthy.
  3. He lives in a fancy house.

Your Neighbor’s Grass is Brown!

Have you ever seen a friend’s or neighbor’s fancy car, or heard about her fancy trip, and thought how lucky she is? After nearly 1.5 decades in this business, I’ve heard many people’s stories, and learned that things are rarely what they seem. Specifically:

  1. Each person emphasizes certain expenses, while often keeping other expenses much lower. A person can fly business class, while living an otherwise modest life. Another may lease a fancy car, while renting a modest home. A third may live a simple life in a fancy home. A fourth may pay for a very expensive private school for her children while living a modest life. These are all examples based on people I personally know. I believe that only a small fraction of people who spend big in a few categories, can afford to spend big in all categories. It makes sense to choose the most important things in your life and focus your spending on them, rather than spending evenly across all categories, whether important to you or not, leaving less money to your top priorities.
  2. Many big spenders are chronically stressed. It fits with a recent study showing that income above $105,000 in North America paradoxically leads to diminished happiness. Anyone with high income faces the temptation to spend a big portion of their income. Say you gross $1M and net $600k per year. You save what feels like a respectable 20% of your net income: $120k, and spend $480k. After a number of years, you built a nice investment portfolio of $1M. You are still highly dependent on your income, and replacing such high income can be a big challenge. This can lead to unusually big stress. In addition, high income often comes with big responsibilities (CEO, business owner), putting extra pressure. To sustain $480k of spending from a stock portfolio that can handle sustainable 3% withdrawals, you would need to reach savings of $16M. Such a level of savings is not common, and probably a lot less common than spending of $480k per year.

If you are able to satisfy your basic needs (food, a place to sleep, basic clothes, etc.), and spend modestly relative to your savings, you are under a fraction of the financial pressures of many big spenders. You may think that their grass is greener, but it is brown compared to yours. Peace of mind, lesser dependency on work, and appreciation for the little things in life are worth a lot more than what big expenses can buy along with the stress involved. You are the source of envy of some very big spenders who realize that your grass is greener. Next time you see a big spender, you may replace feelings of envy with some compassion.

Quiz Answer:

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that. [The Correct Answer]
  2. He is wealthy.
  3. He lives in a fancy house.

Explanations:

  1. People often spend money on things they value.
  2. People usually spend money based on their income, even if their total wealth (savings/investments) is low.
  3. People usually spend big money on several categories, but not all.

Disclosures Including Backtested Performance Data

Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50%

How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

Portfolio 1

Portfolio 2

Year 1

0%

-50%

Year 2

0%

100%

Average

0%

0%

If you start with $100, both portfolios will be worth $100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) $100 – 50% = $50. (Year 2) $50 + 100% = $100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add $100 in the beginning of each year:

Portfolio 1

Portfolio 2

Year 1

($100 + 0%) = $100

($100 – 50%) = $50

Year 2

($100 + $100) + 0% = $200

($50 + $100) + 100% = $300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher ($300 vs. $200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up $100 – double the -$50 impact of the decline.

Notes:

  1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
  2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

Quiz Answer:

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50% [The Correct Answer]

Explanation: See this month’s article for an analysis of this scenario.Disclosures Including Backtested Performance Data

Quiz!

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
  2. Buy well established companies that are not going anywhere.
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand.

The Secret to Getting Rich

Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:

Good Action

Bias

Biased Action / Human Nature

Defer spending to invest, and enjoy compounded growth

Present Bias

Emphasize the present over the less tangible future

Invest in fast growing (and volatile) investment classes

Myopic Loss Aversion

Avoid declines, even temporary

Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines)

Recency Bias

Prefer investments that did best in the recent 5-10 years

Diversify across countries

Home Bias

Buy familiar stocks that are close to home

Own small stocks

Familiarity Bias

Buy large stocks that are more familiar

Enjoy momentum

Disposition Effect

Sell too soon, after seeing a gain, and too late after seeing a loss

Buy small & unknown profitable companies

Familiarity Bias

Focus on known profitable companies over less known ones

A couple of notes about the list above:

  1. If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
  2. An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.

If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.

Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:

  1. Think of tangible examples for the tradeoffs. For example, would you give up spending $10,000/year for the next 20 years, in return for $38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of $521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
  2. Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
  3. After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.

Quiz Answer:

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
  2. Buy well established companies that are not going anywhere. [Correct Answer]
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand. [Correct Answer]

Explanations:

  1. Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
  2. Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
  3. As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
  4. Familiarity Bias. See #2.

Disclosures Including Backtested Performance Data