Investment Psychology & Stock Declines

Did your income jump significantly at any point in your life?  If you are fortunate enough to experience that, you may face a tradeoff between feeling wealthy and being wealthy.

If you feel wealthy, you are likely to increase your spending significantly, which can make you less wealthy very quickly.  If this doesn’t make sense to you, Sports Illustrated estimated in 2009 that 78% of National Football League (NFL) players are either bankrupt or in serious financial trouble within two years of retirement.  This is a group of people who typically make several millions each year.  While this is an extreme example, you can get in trouble even without feeling adventurous or being irresponsible.

Say your income jumped from $100,000/year to $300,000/year.  You make the following adjustments to your annual expenses:  $1.5M house, with $72,000/year mortgage payments (30-year fixed loan with 4.5% interest), $18,000 property taxes, $15,000 repairs & improvements, $10,000 utilities + cleaning + gardening, $40,000 private schools for 2 children, $5,000 classes for the children, $20,000 food, $10,000 car payments, maintenance, gas & insurance, $10,000 travel & vacations, $10,000 various types of insurance, including medical & dental & medical bills for the family, $10,000 clothes, toys, household items, etc..  If you don’t have children, you may spend more on nice clothing, eating out, jewelry, hobbies, etc.

I didn’t include all categories of spending, and already consumed your entire net income of $220,000, with nothing left to save.  If you lose your job, you are left with high expenses and low savings.  Furthermore, you have no money left to help your children with higher education, or to fund your own retirement.  By feeling wealthy, and spending accordingly, your financial security dropped lower than before the big raise.

Instead, you can decide to not feel wealthy.  You increase your spending to $120,000 – a significant jump, but low enough to leave $100,000 to save.  Within a few years, you accumulate meaningful savings.  If you lose your job, your savings can carry you for a much longer period of unemployment.  In addition, finding a job to cover your $120,000 in spending will be much easier than replacing the $300,000 salary.  Here are some key ideas for making this work:

1. Keep your focus on spending-to-assets, and strive to reach a sustainable ratio of 3%-4% per year.  While it would be impossible for most people to reach this rate for a long time (even with $300,000 or $600,000 in annual earnings), use any big jump in earnings to increase your spending modestly and your saving rate significantly.
2. Never feel wealthy thanks to high income.  No matter how much you earn, you can end up with no financial security, and no wealth.  It can start with nicer cars, expensive jewelry, a nicer home, vacation home, full-time staff in each of your houses, yacht, private jet, private island, or private jumbo jet.
3. Once you approach sustainable finances, you can increase your spending along with your assets, and enjoy the continued increase in standard of living without losing your peace of mind.

Disclosures Including Backtested Performance Data

Imagine the following: You are a retiree with $10M in a diversified stock portfolio. You sell $50k each quarter ($200k per year) to generate current income. Your portfolio declined by 50% in the recent quarter. Please answer the following questions with likelihood between 1 and 10 (ignore the time spent on acting on your decision):

1. You need $50,000 to cover quarterly expenses. How likely are you to sell an extra $50,000 to lock-in the current value given the potential for further declines?
2. You have an old employee retirement account that has $50,000 invested in bonds. How likely are you to keep the bonds in place (as opposed to selling and reinvesting in stocks)?

STOP. Make sure you have a response in place, before reading further.

People have a tendency to keep their current behavior in place, even when the change would improve their lives. This Status Quo Bias is seen in various domains of life, including investing. The rest of this article will help you recognize and avoid it.

If your answer to #2 is higher than #1, meaning you are more likely to do #2, you are probably subject to the Status Quo Bias. In both scenarios, the difference between agreeing with the statement and not, is having $50,000 extra outside of the stock portfolio. Your preference for financial security may affect your responses, but is likely to keep them similar to each other. Specifically:

1. If you are looking to maximize your short-term security, you would want to sell the extra $50,000, as much as you would want to keep the bonds in the retirement account in place.
2. If you are looking to maximize your long-term security, you would want to avoid an additional sale from stocks, to avoid locking in a 50% loss on the additional $50,000, and let the amount recover with the stock portfolio. By the same token, you would want to move the bonds in your retirement account to your stock portfolio, so they can grow with its recovery.

To clarify further, taking action #1 and not #2 is very similar to taking action #2 and not #1. Phrased differently taking either action would yield similar results (keeping $50,000 away from the stock portfolio).

There is one financial difference, though: #2 refers to a retirement account. Given the tax benefit, you would want to consume money from that account last (under most scenarios), making its time horizon longer than the taxable account. Therefore, cash is more valuable in the taxable account, since the stock investment has less time to recover from any further potential decline. This means that you should have a preference to do #1 over #2, meaning your answer to #1 should be higher than #2.

Why would you prefer #2, if it goes against your financial interests?

Because #2 does not require any action, while #1 requires taking an action. People have more regret as a result of actions than inactions.

How can you limit the impact of the Status Quo Bias?

In every financial decision, focus on the end result, not the process. Imagine reality after you implemented the decision. Picture all changes that result from the decision. This will remove the focus on the action/inaction. Only after picking the best financial result, evaluate whether any effort required would outweigh the financial benefit.

How would you follow these ideas in the example above?

In the example above, if you desire to keep your cash/bond allocation unchanged, it may be best to take the following two actions: (1) invest the bonds in the retirement account in stocks, while (2) selling the equivalent amount from your taxable stock portfolio (assuming you can do so without realizing gains – likely given the recent 50% decline).

Given the low withdrawal rate for ongoing expenses, it seems that the short-term risk is small, making it smart to try to maximize the long-term security. If that is your preference, you would choose to transition the bonds to stocks, and not sell extra stocks from the taxable portfolio.

Disclosures Including Backtested Performance Data

How would you like a reliable forecast of your stock portfolio’s returns? While countless magazines, radio shows & TV programs are devoted to the task, most attempts are fruitless. This article points to one measure that can help in a specific case: a low Price/Book ratio when analysts predict a stock market crash.

First let’s define “Book” (or: Book Value) in the expression Price/Book (P/B in short). Book Value is the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated.

P/B measures how much people currently pay for the assets of the company, and can be seen as a measure of how cheap it is. When the P/B is high, the company can be viewed as expensive and when it is low, the company can be viewed as cheap. The intuition is simple: the company has a given set of assets determining its book value. For the given book value, a high P/B results from a high price, and a low P/B is the result of a low price.

Your first instinct may be to hold more stocks when their P/B is low and fewer stocks when their P/B is high. There are several problems with avoiding stocks at times of high P/B:

1. The P/B can be high and increasing for a number of years, before reverting. Avoiding stocks could result in missing substantial gains for years. For example, 2004-2007 were 4 years with relatively high P/B for both of QAM’s stock portfolios. At that time both portfolios more than doubled. Even at the lowest month of the 2008 decline, the portfolio did not decline below the 2004 level, so even if you were perfect at buying back the portfolio at the lowest month, you would have still missed gains.
2. When the P/B is high, it may decline gradually, more slowly than the increase in company book values. This would result in prices never declining as a result of the high P/B.

There is also a problem with over-investing in stocks (using borrowing-to-invest) at times of low P/B:

1. A low P/B can decline for a while before reverting. This could be accompanied by a severe decline in your portfolio. While the risk declines the lower the P/B, you should always be prepared for a severe decline. This does not contradict the following: If you get/save money while your portfolio has a low P/B, it is very wise to add it.

While it is impossible to time the market simply by tracking the P/B of a portfolio, there is one case that may be helpful to note:

When there is great fear of a substantial stock market crash, and the Price/Book of your portfolio is relatively low, e.g. under 1, the likelihood of a multi-year deep decline is not unusually high.

While we do not have long-term data of Price/Book values, during the limited history available (since 1998 for QAM’s portfolios), we see that significant market declines typically started at times with high Price/Book ratios, not low ones.

This is also logical, supporting the limited statistical evidence. When the price of a company is lower than the value of its assets, you would expect the company to be appealing to the buyers of its stock. Each company is different, but for a diversified portfolio holding many different stocks in different industries, the claim is more likely to hold.

When do people fear a multi-year decline, despite a low P/B? When there is high uncertainty, and fear of a recession, stock prices tend to decline. Once in a while, the decline keeps going to the point of a low P/B. Specifically, as the price declines, if the book value does not decline at the same speed, you get a lower P/B. Many investors and analysts fail to notice or acknowledge how cheap stocks have become, and keep predicting multi-year market crashes despite the low P/B, leading them to sell stocks.

Why does this happen? Investors focus on portfolio prices, since they represent the current value of their savings. The Price/Book value is a less intuitive measure that gets neglected. When there are uncertainty and gloomy predictions, prices tend to drop. People tend to view their investments’ appeal based on these predictions, and worse, based on recent performance. The idea that a company that costs $100 one day, and $80 a month later is 20% cheaper, unless its book value also dropped, is not intuitive enough to follow.

How can we use the claim above to help your investment results? When you hear an investment professional predicting a multi-year decline, look at the P/B of your stock portfolio. If it is low, this may be a case of irrational panic. As long as you are prepared for a decline at any time (through holding bond/cash reserves, or by limiting the withdrawal rate from your stock portfolio), you have a chance of having nice returns by holding onto your investments, until the fear goes away. If you have money to add to your stock investments you may even make excess returns.

Disclosures Including Backtested Performance Data

Does the stock market affect your mood? Do you feel happy when the stock market is up and upset when it goes down? This is natural, and it affects many of us. A problem occurs when people act on these feelings. This article analyzes the drivers of change in stock prices, with some practical consequences.

Stock prices change every day. Some of the changes are due to company-specific information, and some are related to the whole economy. Changes related to the economy may occur in the following sequence:

1. Economic data is released, resulting in change of expectations for the future of the economy. The change is assessed relative to the prior expectations.
2. This new economic data gets reflected quickly in the stock market. For example, an expectation for a slower economy than previously expected will cause the stock market to decline soon after this information becomes public.
3. When the stock market declines, some individuals and professionals become negative about the future of the stock market, and expect it to keep going down.

This last step is where the logical sequence breaks:

1. You can expect the future of the economy to affect today’s stock prices.
2. The future of the economy should not affect tomorrow’s stock prices. Once the data is released, it gets reflected in stock prices quickly (typically within seconds to minutes). There is no economic reason for stock prices to repeat their adjustment to the same data the next day.
3. You cannot expect today’s stock prices to affect tomorrow’s stock prices, since prices are related to expected economic value, not prior prices.

Furthermore, stock prices do not change according to the expectation for the economy, but according to the changed expectation for the economy. The results may be counterintuitive, for example:

• If investors expect the economy to boom in upcoming quarters, data indicating a slower expected expansion would be a reason for stocks to decline.
• The same works in the other direction: if investors expect the economy to slow down in upcoming quarters, new data indicating a more moderated slowdown would be a reason for gains in stocks.

Once you digest the ideas above, there is another factor to consider: Stock valuations ultimately gravitate towards neutral values:

• The higher the valuation (e.g. Price/Book Value) of stocks, the more the price will sink given a less positive prediction for the economy.
• Similarly, the lower the valuation of stocks, the more the price will jump given a less negative prediction for the economy.
• For example, in March 2009 stock valuations hit extremely low values. When bad news came, but just slightly less bad than before, stock prices went up. Given the extremely low valuations, instead of a moderate increase, stocks shot up very high very fast.

One more phenomenon plays into the mix: Given that investors (including some of the biggest institutional ones) are not perfectly rational, they sometimes tend to keep buying stocks that are already expensive or sell stocks that are already cheap. This is what I referred to as “the herd effect” in prior articles, and what is called “momentum” by the investment profession. The results:

• You can make money by buying expensive stocks (or selling short cheap stocks) for some stretches of time. Given that valuations do not change indefinitely in one direction in the long run, these upward and downward runs get broken by huge upward and downward corrections. As a result, stock valuations cannot be used to predict the near-term changes in stock prices in a systematic way.
• In general, high valuations cannot be used to predict declines even for long time horizons, since book values of companies tend to grow over time. By the time a bubble gets popped, book values can keep up with prices, resulting in the next bottom being higher than current prices. For example, Extended-Term Component by QAM was more expensive than usual in the end of 2004. Despite that, it had gains all the way to the end of 2008 (around the recent bottom of the worst recession in nearly a century).
• Low valuations can be used to predict gains in the long-term. Global stock markets always grow in the long run (at least as evidenced in the past few hundreds of years, and as logically expected). The chances of gains, and specifically abnormally high gains, go up the lower the current valuations are.

One way to benefit from this last point is to buy stocks with low valuations (Price/Book Value), and hold them for the long run.

Summary

Not much can help us predict the future of the stock market. The best you can do is hold stocks with low valuations for the long run, to enjoy high average returns.

New economic data affects stock prices today, but neither this data or current stock prices can do a lot to help you predict future stock prices. Understanding this can help individuals as well as professionals avoid ‘forecasting yesterday’.

“Valuation” is a term for how expensive a stock is. Two common measures are Price/Earnings and Price/Book Value.

Disclosures Including Backtested Performance Data

Can you think of the easiest way to avoid continued stock-market declines, during a recession? This article presents the most common strategy, based on ideas from various investors. It guarantees that you stop your stock losses, and you are likely to feel a big sigh of relief. There is one catch – read on for details.

The strategy has different variants, but the basics are common and are very intuitive:

1. Follow the economic news. Whenever you hear concerns about the economy start selling your stock portfolio. If it seems like we are getting into a deep recession, sell your whole portfolio, until things look better.
2. Keep following the economic news. Once the economists become more positive, start buying stocks. When the economic outlook looks really good, make sure you are invested heavily in stocks.

The benefits of this strategy are easy to identify:

1. Whenever the economy is doing poorly and you hear gloomy news on a daily basis, you get to be outside the stock market. You can smile seeing your accounts retaining their value, while people around you are nervous about their investments.
2. When everyone is optimistic, you get to have your money in the stock market, enjoying being invested when there is such excitement around.
3. At all times, you can feel good about your actions. Not only are they intuitive – many people around you are acting the same way, providing a great support network.

There is one big catch: The stock market does not go up and down together with the economy and the sentiment on the news. It tends to precede the economy by 6-12 months. Whatever news you hear is already reflected in stock prices, and only the unknown affects the stock market moving forward. As a result:

1. When you hear about the economy doing poorly, the stock market is already down substantially. When you learn that we are in a recession, the stock market tends to be past most of its decline. For example the 2008 recession was announced by the National Bureau of Economic Research on December 1, 2008 – close to the stock market bottom.
2. When there is optimism, the stock market has already experienced a substantial portion of the recovery.
3. Given the predictive nature of the stock market, bottoms tend to be reached at the moment of greatest pessimism. By selling on pessimism, you are likely to sell low. Optimism and comfort are reached when the stock market is much higher.

The strategy presented virtually guarantees that you sell low and buy high! While it provides great psychological comfort, it comes at a price of giving up some of the greatest run-ups in stock prices in history, and getting substantially reduced long-term returns.

For example:

1. On December 9, 1974, the cover story of “Time” magazine, “Recession’s Greetings” was very gloomy. A year later, the Dow Jones Industrial Average was up 47.7%, with a new “Time” cover story: “U.S. Shopping Surge”.
2. On March 10, 2009, there was great pessimism about the world economies as the stock market hit bottom. A couple of months later, the globally diversified portfolio, Long-Term Component, was substantially higher, as there were some initial signs of optimism.

Summary

It is easy to invest in a way that feels good. This article provides the guidelines for that. Unfortunately, doing what feels good bears a large price tag on your investment performance. You have to make a choice between what feels good for you and what is good for you.

Disclosures Including Backtested Performance Data

When you face a substantial decline in your portfolio, it becomes tempting to keep the money in cash until the recovery begins. The greater the decline, the greater the temptation. Watching the news and reading economic analyses makes it even tougher to stick to your long-term plan. As demonstrated in the previous article, “Can You Avoid Market Declines?” (Hanoch February 2009), finding the bottom of a decline is virtually impossible. The problem is compounded by the difficulty in buying back when the portfolio is lower and the economic atmosphere is worse. Fortunately, if you established a well thought-out plan in advance, you may not need to face this temptation.

During declines, people try to reduce “Market Risk” – the risk of a decline in stock prices. There are two additional risks that should always be considered as well: “Inflation Risk” – the risk of losing purchasing power over time, and “Longevity Risk” – the risk of outliving your money. As you will see below there is a clear tradeoff – reducing market risk increases inflation risk and longevity risk.

The reason for the smaller focus on the other two risks is the eagerness to deal with the current pressing problem, and the need to feel in control. Since the latter two risks are not imminent, people tend to neglect them in favor of market risk.

The best way to deal with market risk is to sell some stocks. If the plan was not designed in advance to prepare for substantial declines, this is an unfortunate necessity during a decline. When done it should be a cold and rational decision that is followed in the long run, especially as stock prices go up. The desire to get back in the market as economic conditions improve is likely to lose you money and increase your inflation and longevity risks. Let’s review these now.

Inflation Risk: During severe declines, governments (both democrat run and republican run, each with their own emphasis) tend to stimulate the economy, and create the risk of inflation in upcoming years. If you hold cash or bonds during this period, you risk losing your purchasing power, since an investment that is free of market risk is almost guaranteed to lose money after taxes and inflation. This means that while maintaining the stock allocation can result in a number of years until recovery, cash or bonds are not likely to ever recover your losses.

Since inflation is the increased prices that companies charge for their products and services, company ownership (stocks) is the best way to protect yourself from inflation risk.

Longevity Risk: By selling stocks during severe declines, you realize the substantial losses, but risk missing out on the gains during the recovery. As a result, you risk outliving your money. If you maintain the lower allocation to stocks in the long run, the loss in purchasing power of your cash and bonds increases the risk of outliving your money.

By keeping your money in stocks, you miss the speculative opportunity to outperform your stock portfolio, but you also ensure that you gain the impressive long-term after-costs returns of stocks.

Conclusion

If your annual withdrawals from your portfolio are conservative (e.g. 2%-5%, depending on the portfolio), and your portfolio is globally diversified, with no individual stock selection or market timing, you may be facing greater inflation and longevity risks than market risk, especially during declines in your portfolio. In such case, you may want to think twice before selling stocks and changing your plan.

Disclosures Including Backtested Performance Data

You are in the midst of a severe decline, with a combined length and magnitude that tend to occur a few times in a lifetime. People are in panic. According to the news, you expect the decline to continue for a very long time, and everyone you know is rushing to sell whatever is left of their stock investments. Should you sell?

Target Audience: This article limits the discussion to stock market investors, not speculators. Investors use the long-term growth of stocks to provide them with long-lasting income, as follows:

Stock investor: Invests globally in thousands of companies across sectors, with no individual stock selection, and limits annual withdrawals to a small percentage of the portfolio (for QAM’s Long-Term Component – 4% of the peak value of the portfolio).

All QAM clients are investors, since QAM refuses to speculate with their money. Two typical groups of investors are:

1. Young people that need to build a nest egg for their retirement.
2. Retirees that need current income throughout their retirement years.

Discussion: Investors had abysmal experiences in trying to time the stock market (the topic of the next article). When dealing with your life’s savings, and when counting on them for your daily livelihood during retirement, you cannot afford to try to guess the turning points of the stock market.

Instead, you can benefit from companies that provide the world population with products and services as cheaply and efficiently as possible. Given that people have not changed their preference for getting these products and services in the most efficient way, the system should keep working, and you should keep enjoying its benefit without speculating on the turning points of the different stages of the business cycle. Now we discuss a few important factors that should keep you strong and relaxed through tough declines.

Government stimulation: After the painful experience of the Great Depression, the U.S. government and many other governments learned that during declines the smartest thing for it to do is stimulate the economy. Note that this principle was adopted by post World War II U.S. governments, regardless of the party in power. It is done in many ways, including reducing interest rates and providing substantial loans and investments that help keep the economy going.

To finance this activity, the government issues bonds that are essentially long-term loans. Given the long-term growth of the economy, the government eventually collects the money to repay its loans. This has proven to work throughout the U.S. history with a track record of no defaults on government loans. This tremendous security, combined with the great fear of the stock market, leads people to buy government bonds en mass right in the depth of stock market declines. As a result, the government is able to raise substantial amounts of money to shore up the economy, at a very low cost (low interest rates on bonds).

The cost of not selling: If you depend on your stock portfolio for current living expenses, it might seem painful to sell at such a decline, and it might seem even scarier to think about the cost of withdrawals if you keep your money invested throughout a prolonged decline.

Let’s analyze the cost for Long-Term Component in an extreme case, substantially worse than anything seen in the past 40 years:

1. A 5-year decline averaging at 33%.
2. Annual withdrawals of 4% of the peak value of the portfolio.

The damage:

• Each dollar withdrawn at a 33% decline costs 50% extra (=100%/(100%-33%)-100%).
• Therefore, each 4% annual withdrawal costs an extra 4% x 50% = 2%.
• In total, the 5-year withdrawal costs an extra 5 x 2% = 10%.

This dooms-day scenario costs 10% of your portfolio.

The benefits of not selling:

1. Given that the economy keeps working in good times and in bad times, declines tend to follow with rapid growth that makes up for the lost time and value of the stock market. Historically, we’ve seen that the longer and deeper the decline, the more impressive the recovery.
2. You already experienced a lot of the pain. From this point you, most likely, have a lot further to go up than down. For example, if you are at a 30% decline that will bottom at 40%, your current investment:
   1. Will bottom at an additional 14% decline (=100%-(100%-40%)/(100%-30%)), but
   2. Will go up by 43% (=100%/(100%-30%)-100%) by the time it recovers.

Conclusion: Stock investors (as defined above) can support their goals more by buying rather than selling at a deep decline. Since you cannot predict the performance of your portfolio in the next few months, you should stick to your long-term plan and keep the split to stocks vs. bond/cash reserves as stated. Specifically,

1. If you are working and have extra money to save, you can benefit greatly from investing it.
2. If you are retired, you can continue with your limited periodic withdrawals, and continue to enjoy your retirement years with great peace of mind.

Summary

If you are a responsible investor in the stock market, whether you have a time horizon of 30 years, or you depend on your investments for current retirement living (at limited withdrawals, depending on your portfolio), you can benefit from the tremendous power of the world economies to support your financial needs. You can leave the emotional swings of stock investing to the speculators. Instead, you can focus on your daily activities with great peace of mind throughout all market conditions.

Disclosures Including Backtested Performance Data

Do you believe that your diversified stock portfolio will go up or down in the next 12 months? If you answered “down” – you are not alone. Most people are pessimistic after declines. This article presents two main reasons for this belief and a flaw with both reasons.

Reason #1 : It went down recently, and is likely to keep going down . We tend to remember recent events better than older events, and give them greater importance. This is a psychological effect called “Recency”. In the context of investing, we tend to believe that declining stock investments will keep declining. Since stock markets go up in the long run, with fluctuations around their long-term growth, it is impossible that declining markets will keep declining forever.

Even when people understand this contradiction, they think that their stock portfolio will go up, just not anytime soon. They plan to keep money outside the stock market until it starts going up, but fail to find the turning point. One reason is that stock prices fluctuate within long-term up and down trends. By the time they realize that the recent increases are the beginning of a long-term recovery, they miss out on enough of the gains that they underperform a buy-and-hold approach.

Reason #2 : The economy has slowed down and is believed to keep slowing further . This belief is actually irrelevant (whether flawed or not) to the prediction of stock performance. Stock prices reflect the belief about the future value. It declines because there is a majority belief that the economy will slow down in the future. The behavior of the stock market in 12 months reflects the expectation regarding the economy many months later, which is much harder to predict than the near-term future of the economy.

One consistent truth : Since people that try to predict the near-term future tend to underperform their own portfolio, the best thing you can do is focus on a more predictable pattern: the long-term. In the long run, stock markets tend to go up. This was true in the past since people depended on companies to produce their goods, and should keep holding true as long as people will keep depending on companies for their daily consumption of goods and services. Human preference for getting things easily and cheaply is likely to keep the concept of companies going, and as a result: stock prices growing.

Solution : Your best strategy is to be optimistic about your investments at all times. Given the substantial long-term growth of stock markets, you can be even more optimistic during decline periods. There is no guarantee for a quick recovery after declines, but the longer and/or deeper the decline goes, the steeper the recovery is likely to be.

Summary

Psychological biases and misconceptions drive us to be pessimistic about the future of our portfolio right when we have more reasons to be optimistic. Worse, it leads some people to gamble with their own money, trying to time the market. Staying consistent with the stock portion of your investments is not only the smartest plan; it is also the most conservative.

Disclosures Including Backtested Performance Data