Investment Psychology & Stock Declines

Close your eyes and imagine the following future. Over the next 2 weeks, your portfolio declines by 20%. You read the news trying to understand what caused such a rapid decline. There is no forecast for a recovery in the foreseeable future. This is what you learn:

1. Millions of Americans took mortgages that require only minimal payments in the first few years, and now they cannot afford to make the full payment. They defaulted on the payments and lost their homes. Some lost their investment homes and some lost their primary residence.
2. As a result, the market was flooded with homes for sale and the real estate market crashed.
3. Homeowners who were able to keep their home have a lot less equity in their home, if any. They cannot take more loans, and they have no money for discretionary spending.
4. As a result, the whole economy is heading into a recession.

As you are debating about how to deal with the situation, the decline is going on uninterrupted. A year passes, and the portfolio is down 50%. You go back to the news to assess the situation, and it looks worse:

5. We are officially in the midst of a recession. Corporate profits are low, unemployment is up.
6. The tension with Iran is increasing. There is a real fear of war.

You hold onto your investments, checking the news daily, hoping for a solution to come, but things get worse. Your portfolio just reached a 60% decline! The explanation:

7. The world is consuming a lot more energy, while the tensions with major oil exporting countries are only increasing. There is a rapid increase in oil prices. The price per barrel just crossed $150 (up from $60), resulting in a collapse of economies all over the world.

You see in the front page of the investment magazines: “We are facing a New Reality”. “We have never seen anything like this before. A new reality requires a new way of thinking and planning.” People are rushing to rescue the rest of their money from the declining stock market.

What would you do? Before reading the answer, please try hard to envision this situation. Try to digest all the emotions, information, news and talks around you. How would or should you handle this situation? Would you sell your whole stock portfolio to stop this stress and the very real risk of further declines? Would you sell part of the portfolio? Is it smart to keep holding on to the portfolio as it is going straight down?

I should emphasize that this scenario is very possible. There is no reason to think that each of the things above could never happen. There is also no reason to believe that there will not be declines worse than we have seen in the past few decades. The big question is: Did your investment plan take into account such a possibility? Should you keep following it blindly?

 

Answer. As long as you have a well thought out plan, you can do the following:

1. Avoid obsessing about the news in order to get investment solutions. Your well crafted plan should be the only answer to your investments. Listening to the news very frequently and reading investment magazines that track recent events will not do any good for your investments and is definitely not good for your health.
2. Open your investment plan and read what it says. It should specify how to deal with recessions. Specifically, for QAM clients, it should specify a certain amount that you should keep in reserves for recessions. If you have more than the amount specified, and don’t intend to spend it soon, add it to the portfolio. If you have less and no source of income to replenish it, it’s fine. For any cash needs beyond your income, you should use the reserves, until the portfolio recovers. Once it recovers, you sell enough of it to replenish your cash reserves.

Why be Optimistic? Please refer to the article “Should you sell your declining stock?” (Hanoch, May 2005) for a detailed explanation for why globally diversified portfolios are always expected to recover.

There is no way to know for sure how long declines can continue despite the continued production of companies. The good news is that the longer or deeper the declines, the faster they are likely to reverse and the bigger and quicker the increases. The more the portfolio declined, the more it makes sense to hold on to it.

In addition, by holding a globally diversified portfolio that reflects whole economies all over the world and avoiding any type of stock selection or market timing, your portfolio declines are likely to be shorter than average.

Test yourself. Look at your investment plan. If you are thinking: “This is my investment plan for normal times, but there are always cases that we cannot anticipate and that require different thinking”, you are setting yourself up for failure. It is too late to plan when you are in the midst of a crisis. You are not only emotionally biased, but you may be in financial trouble if you did not keep enough money outside the stock market, before it declined .

For every $4,000 you take out at a 60% decline, you pay an additional $6,000 penalty (that’s 150%). Explanation: $10,000 declined to $4,000. When taking out $4,000 after the decline you paid a penalty of $6,000. You should keep enough cash in reserves for you to feel comfortable not withdrawing from your stock portfolio during the worst declines, unless there is no alternative. If you have any doubts, you are not keeping enough in reserves, or you do not understand your plan.

Peaceful Investing! Once you set the plan right, you will realize that there are no “New Realities” and there is no need to check the news or reassess your plan for a 5% or even 50% drop. You will not be caught by surprise with declines and will not panic when they happen. You will just accept them as a part of life and go on with your life. If you are lucky enough to have spare income during these declines, you can even make profits of 100% or more during the 2-3 years of recovery, by adding money to your portfolio in the midst of the declines.

Disclaimer: This article refers to globally diversified stock portfolios that stay unchanged (other than rebalancing to the target allocation) throughout all market conditions. The results are not likely to be true when using individual stock selection or market timing. In addition, this article refers to plans written by QAM – different investment plans are likely to require different actions.

Disclosures Including Backtested Performance Data

Did you ever get a stock tip? Do you know of a company that looks very promising? Before rushing to invest in the company, this article will point out a critical principle that many investors overlook.

First, a disclosure is needed: QAM does not buy individual stocks for its clients or for its members. Many academic studies show that most investors and professional money managers lose money when compared to market indexes. Therefore, QAM views individual stock selection as a speculative activity that may have entertainment and excitement benefits, but no expected financial benefits.

Note that this disclosure does not apply to stocks and stock options given by an employer. These may be held for a limited period, to reap the value of discounted pricing and tax benefits.

If you are considering buying a stock, whether for speculation or entertainment, you want to maximize your chances of making a profit beyond the market indices, to justify the risk taken. The following principle will help you avoid certain losses that many stock-pickers incur.

The value of a stock is negatively related to its price. Specifically: The more expensive a stock is, the less attractive it is The cheaper a stock is, the more attractive it is

Note the following implied and related points:

1. The stock price compared to the company’s earnings (P/E ratio) gives one indication about whether a stock is expensive. This should be your first step in choosing a stock. A glaring warning signal about a dangerous stock is a high P/E ratio. If people would have used this single warning signal during the tech boom, they could have avoided most of their losses.
2. The more the stock price increased recently, the less money you will get to make. This is by far the most important point to remember. Not understanding this is a big reason people underperform the general stock market. Buying a hot stock is like buying a car after a huge sale ended, or when there is huge demand and the dealer is asking for an excessive price.
3. A poorly performing company may not be a bad investment. An important factor to consider is whether or not the company’s stock price is low compared to the actual future earnings of the company. This requires correctly predicting the future earnings of the company. For the price to be low, most smart and hard working analysts in the world should disagree with your opinion about the future earnings and be wrong, while you should be right.
4. The earnings of a company may be distorted or stated based on different assumptions for different companies. A good analysis should include a detailed review of the footnotes of the company’s financial statements and other information that is not highly visible.

To Summarize

Because of all the difficulties in consistently finding good investments, you would be best putting your money in index funds and focusing on the best asset allocation, tax planning, estate planning, etc. If you cannot fight the urge to beat the market, please treat it as speculation or entertainment, and allocate to it a small amount (e.g., 5% of your money or less) accordingly.

Disclosures Including Backtested Performance Data

Have you ever heard someone say, “This time it’s different! This time the stock market may not recover from the recent declines?”

Throughout recorded history the stock market never declined without a full recovery. How is that possible? In order to answer this question, we need to understand what a stock is. A stock represents ownership in a company. In order for a highly diversified portfolio to decline without recovery, the concept of companies should stop working. This requires people to prefer to build their own homes, manufacture their own cars and grow their own food.

By now it is probably clear to you that there is no real risk for an irreversible decline. But our basic instincts keep leading us to expect declines following declines. This is the result of a psychological bias that makes us put more weight on the recent history when trying to understand long-term trends.

This is a natural human instinct. We tend to prepare for earthquakes just after living through a big one. We prepare for floods after our home was flooded. Similarly, we expect declines to continue, possibly without recovery, just after a decline has started.

It is as illogical as it is natural to expect this. The stock market tends to go up and down in value in a cyclical way. These cycles vary in length and magnitude and have no predictable pattern, so you cannot predict the near-term future based on the recent past. If you want to make the most thoughtful bet on the future change, it would be a reversion to the long-term average. This principle worked during all past declines and is the one principle that agrees with the idea that people like using companies to make life easy.

Once you understand this idea you can live relaxed through all market declines. But in addition to peace of mind, there is a large financial benefit. When the stock market declines, many people are unable to fight their human instinct, and sell stocks after they declined in value. At the same time, investors that understand the cyclical nature of the stock market, make an extra effort to buy during the decline periods. This can be financially rewarding beyond any imagination; the bigger the recent decline the bigger the reward.

Note that the recovery tends to be most dramatic in its early phases. As a result, people who wait to identify the bottom before buying in, usually give up most of the gains compared to people who buy as soon as they have the extra long-term money in their hands.

Since we have never experienced an irreversible decline in the stock market, and having one in the future is against the human nature of wanting to get things done easily and cheaply, the risk for it is nearly nonexistent. If you have the urge to worry about something, you can focus on more likely risks: an earthquake, flood, fire, sudden death and plenty of other rare but possible catastrophes. Otherwise, you can just enjoy life, while seeing your money grow rapidly – not every day, but over the long run.

Caution:

1. The discussion above is based on holding a highly diversified portfolio, while making no changes based on any type of analysis or predictions. Changes must be limited to rebalancing in order to bring the accounts in line with the intended portfolio allocation.
2. You should keep money outside the stock market (in cash or low risk bonds), to provide for your living expenses during significant recessions. This amount should be planned in advance, specified in a written investment plan, and kept regardless of the market conditions. The recommendation to add money to the stock portfolio during declines refers only to money available beyond these reserves.

To Summarize

Our basic intuition and instincts are our biggest enemies in investing! By setting them aside and using cold logic, we can benefit from financial peace of mind at all times. In addition we can enjoy enormous financial rewards if we happen to come by some spare money that we can invest for the long run during declines.

Disclosures Including Backtested Performance Data

If you accumulated a large amount of money, one of your biggest fears might be losing it during a severe stock market crash like the Great Depression.

This article analyzes several portfolios that could survive the Great Depression, ranking them by the security level that they provide. The table below presents the following information about these portfolios, based on data from 1927 to 2005:

The highest amount of annual fixed income that a $1,000,000 portfolio can provide and still fully recover from the Great Depression. It accounts for taxes and inflation. The relative security level of the portfolio, when invested during the Great Depression. The portfolio allowing for the highest withdrawals is the safest. Viewed differently, for any required withdrawal rate, the safest portfolio is most likely to outlive the Great Depression.

Some simplifying assumptions, that should not affect the general conclusions, are made:

1. The total tax rate is assumed to be 35%. In practice, there may also be state taxes, and long-term stock gains are currently taxed at 15% . This assumption presents the stock portfolios more negatively than they really are.
2. There are no transaction costs. These should be minimal for large portfolios.
3. There are no mutual fund fees. These are not negligible, but are small enough to not affect the security ranking of the portfolios.

Portfolio		Annual fixed income per $1,000,000 portfolio	Security level during Great Depression
Long-Term US Government Bonds		$5,0001	Lowest
Long-Term US Corporate Bonds		$7,4002	Low
Stocks + Long-Term US Corporate Bonds3	$0 bonds	$15,6004	Medium
	$200,000 bonds	$27,3004	High
	$500,000 bonds	$40,0004	Highest

¹ $5,000 = 0.5% x $1,000,000; 0.5% = 5.5% x (1-0.35) – 3.1 = average returns – taxes – inflation

² $7,400 = 0.74% x $1,000,000; 0.74% = 5.9% x (1-0.35) – 3.1 = average returns – taxes – inflation

³ The bond component is used only during recessions, and is adjusted with inflation. The stock portion is invested using the following indexes: 1/3 US Large Value and 2/3 US Small Value.

⁴ The figures were calculated using a spreadsheet that tracked the annual values of the stock component, bond component and withdrawal rate, based on the annual returns of the different components and inflation. The withdrawal rates of 1.56%, 2.73% and 4% are the highest values that resulted in a portfolio that recovered and kept growing until 2005, as simulated. Detailed values are available upon request.

Note that there are many other investments that are considered very conservative. These include: CDs, insurance, fixed and variable annuities, municipal bonds and corporate bonds. A common trait to these investments is that they all depend on the solvency of a single company or entity. If the company issuing any of the above declares bankruptcy, your investment is at risk. During the Great Depression, this happened to many companies, so we avoid discussing these options. Only investments that can be significantly diversified (e.g., using index mutual funds) were considered. The two main categories are bonds and stocks.

Note several remarkable findings:

1. The portfolio of government bonds was effectively the riskiest portfolio. This is remarkable since government bonds are considered virtually risk-free, given that the government can always raise taxes to repay its debt. Any withdrawals above $5,000 resulted in depletion of the portfolio.
2. The portfolio that is usually considered riskiest: 100% stocks ($0 bonds), was much safer than all bond portfolios, allowing for a 2-3 times higher withdrawal rate.
3. A stock portfolio that included a fixed amount of bonds to be used only during recessions was the safest, allowing for a remarkable $40,000 withdrawal rate after inflation and taxes.

A few notes that make the results above even more remarkable:

1. We used a stock portfolio that is concentrated in a single country (US) while the country experienced a severe depression. A globally diversified portfolio would increase the stability of the stock portion, and would require more in stocks and less in bonds.
2. The analysis assumes that we started investing at the same year the depression started (1929). This is the toughest assumption we could make and is necessary from the most conservative viewpoint. If you would use any other beginning year, the results should favor portfolios with a higher stock allocation.

Note: Any allocation to stocks assumes avoiding market timing or specific stock selection. These are strategies that made rich people poor during the depression, and are avoided altogether.

To Summarize

If you want your money to provide you with fixed income that grows with inflation despite severe economic disasters, the most secure solution may need to include a significant stock allocation. We don’t know what the future will bring us, but we do know that a large diversified stock allocation was necessary to outlive the greatest recorded economic disaster in recent history – the Great Depression.

This is great news, because you have to hold stocks to avoid losing your long-term investments and you have to hold stocks to grow your investments significantly. One decision promotes both goals at once.

Disclosures Including Backtested Performance Data

Volatility is known as an undesirable thing that you should strive to minimize. This is very logical – when you invest your money, you want it to grow. You want to be able to take it out whenever you want or need and make a profit.

Unfortunately, investments that grow steadily with no declines provide very low returns. After considering inflation and taxes, you are left with very little gains, if any. Good examples are money market accounts, CDs and short-term government bonds.

Can you get higher returns? Yes, you can get much higher returns! But it comes at a price: volatility. Stocks, on average, provide much higher returns in the long run, but they also may decline in value. You may even lose your whole investment!

How can you avoid losing your whole investment? Luckily stocks as a group tend to grow in the long run. Globally diversified stock portfolios have never declined without recovering. Our desire to get things done as simply and cheaply as possible is what keeps companies growing.

As long as you keep your money diversified over many companies in different industries and countries, you are not likely to see it disappear. In addition, you would have to avoid mutual funds that research companies and try to choose specific stocks or the timing of investments, since the wrong decisions may lead to irrecoverable losses.

Can you avoid losing any money? If history is any indication for the future, yes! If you can hold on to your diversified investments through decline periods and make sure you sell only after full recovery, you are not likely to ever lose money.

The catch! The catch is that you might need money before your investments recover. You cannot control the timing and the length of declines of your portfolio. During long recessions, you may lose faith in stocks before they recover.

Is there a solution? There is a very good solution: diversify and study the history of your portfolio. There is no guarantee that the future will not be worse than the past, but by knowing how your portfolio reacted to catastrophic events, you can get a sense of how long severe declines tend to last. With that information at hand you can achieve two things:

1. You can plan for a catastrophe worse than anything you’ve seen in decades, and keep some money in stable investments to support you through these periods.
2. Whenever your portfolio declines, look back at history, recall why companies have always existed, and get ready for a recovery. The longer and deeper the decline, the bigger the recovery.

Can volatility be good? Yes! So far, we treated volatility as something that can negatively affect our investments, and found ways to minimize the chances for these negative effects. But I would dare to go one step further and claim that we need volatility. The high returns we get on our stock investments are a compensation for the volatility. If stocks ever stopped being volatile, the returns on investing in them would decline significantly. Much lower returns would compensate for the lower volatility.

The ideal practical world. Considering that high returns are compensation for high volatility, the ideal world is the one in which we can choose investments offering high long-term returns, and prepare for the volatility so well that it does not put us at any significant risk or stress. Fortunately this solution exists and is simple. Let’s review it:

1. Choose the most profitable investment: stocks.
2. Diversify them significantly, while including the asset classes that tend to grow the most and ones that are least correlated: small stocks, cheap stocks (“value”), international stocks and emerging markets stocks.
3. Avoid any attempts to choose individual stocks that do better than average – you will have no way of being truly confident that huge declines will be followed by rapid growth.
4. Learn the portfolio’s long-term historic behavior. Make sure to choose a long enough period that smoothes out anomalies. This is normally at least 25-30 years. Find the length of the longest decline of the specific portfolio you constructed, and prepare for worse than that.
5. Keep enough money outside the stock market, to provide for you during the period of decline you chose to be prepared for.
6. Put the rest in your diversified stock portfolio.
7. Make sure you never deviate from your plan! The only reason to update your plan is changes in your own circumstances, not moves in the portfolio.

Smile! Now you are ready to get excited and smile whenever your portfolio goes down, including occasional significant declines – this is what keeps your pay so amazingly high.

Disclosures Including Backtested Performance Data

How many times have you asked yourself in the past, “Should I sell my declining stock?” This is one of the toughest questions investors have faced since stocks existed. If you could know that your declining stock will recover soon enough, you would have the potential of becoming rich from stock investments. Not only would you not sell the stock, you would want to buy a lot more of it. The deeper the decline, the more you would want to buy.

Unfortunately, any particular company could declare bankruptcy, resulting in up to 100% loss of your investment. There is no perfect recipe for deciding whether to sell a declining stock, making individual stocks speculative investments.

What if you could own thousands of stocks in many countries all over the world? When this portfolio declines, can you assume it will recover? You can own such a portfolio using index or asset class mutual funds. In the history of this portfolio, this globally diversified portfolio fully recovered from all declines within several years, as measured since the beginning of the decline.

These statistics are very comforting, but history, no matter how long, may not always repeat itself. Let’s try to think about what it takes for a decline to be irreversible. In order to do that, we need to understand what stock investments are and what makes them grow.

The history of companies. Many years ago, individuals and families grew their own food, sewed their own clothes and built their own houses. There were no companies, and people took care of their needs on their own. Over the years, people found out that they could specialize doing different tasks, and do them much more efficiently. Using machinery, it was easier to produce large quantities of goods.

With advanced transportation and communication, people were able to serve large numbers of people. This led to people grouping together to form companies that serve whole countries, continents and even the whole world.

As a company became large, it was usually impossible for a single person to provide money to operate it. The need to raise large amounts of money led to the formation of large groups of people who owned the company. In order to split the company ownership, they divided the company to many small parts – what we call “stocks”, and sold different amounts of them to individuals.

By dividing the company into small enough parts, any individual can buy today a part of a company for as little as a few dollars.

Why do companies go up in value? Companies buy materials and, using the work of individuals, create products that have a higher value than the materials and human resources used. Whenever a product is created with higher value than its components, it can be sold for a profit. This profit raises the value of the company. This is the natural state of a company that offers a product or service in need, and does it more efficiently than the individual consumer.

Can all companies decline with no recovery? In order for companies around the world to decline irreversibly, the process of specialization and mass production should reverse. More people would have to create products for themselves less efficiently. If you believe that a diversified global portfolio can decline irreversibly, you probably believe in people wanting to work harder for their needs.

What if there is a huge catastrophe? This is a question that often comes up when talking about risks of stocks. Any local catastrophe won’t affect a globally diversified portfolio significantly. The companies in unaffected regions may keep growing.

What about a global catastrophe? A global catastrophe could have an adverse effect on the portfolio. As before, let’s start by looking at history. Humans are amazing at dealing with problems. People dealt with the Great Depression, the World Wars, and extreme oil prices in the 1970’s. How did they do that? No matter how few people survive a catastrophe, they have the same human nature of wanting to provide for their needs as easily as possible. The re-creation of infrastructure with knowledge that already exists should stimulate rapid growth and the portfolio should recover more quickly than average.

To summarize

Humans prefer to get things done as easily and efficiently as possible. This preference should lead to the continuing existence and growth of companies. History measures support this preference.

History shows that people are able to recover from large catastrophes. Not only do they recover – they do so at an accelerated pace maintaining the long-term growth of companies and stocks. It happens with the use of existing knowledge, due to their continued preference to get things done as easily as possible.

Closing notes

This article presents good prospects for positive growth of stocks over the long run, assuming a globally diversified portfolio, with low costs across the board, no stock picking and no market timing. Other strategies could lead to different results. It does not imply guaranteed future returns with any strategy.

Disclosures Including Backtested Performance Data