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THE BLUE MONEY REPORT.
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The Blue Money Report
"The knowledge of an effect depends on and involves the knowledge of a cause."
~ Spinoza
Welcome to the Blue Money Report
Today's Commentary: 05.07.03
Mr. Swedroe was kind enough to contribute this excellent article for the readers of this site.
The article is somewhat technical and can be complicated, but should serve as an interesting sideline to the behavior of all investors. First time investors are especially vulnerable to the constant checking of their mutual funds and can become quite dismayed by recent market trends.
We update our fund portfolios here at the BlueCollarDollar on a monthly basis only because we want to remain timely. But as Larry points out, watching the ticker cross the bottom of the CNBC screen or monitoring your funds Net Asset Value is not only counterproductive, but may also cause more harm than good.
Frequent Monitoring of Your Portfolio Can Be Injurious to Your Financial Health
Behavioral finance has provided us with many valuable insights into how human behavior can impact investment results. As one example, we have learned that individuals are highly risk averse on average odds of 2:1 or greater are required to entice them to accept an even money (50:50) bet. Another related example is that investors feel the pain of losses much more than they enjoy the good feelings generated by equivalent profits. By studying human behavior patterns we can learn how to avoid mistakes that we seem almost programmed to make.
When we look at the historical record of investment returns, we find that the vast majority of long-term returns are derived from just seven percent of all trading months. The returns of the remaining ninety-three percent of the months on average is virtually zero.* The result is that the shorter our investment horizon, the more likely it is that investors will experience a loss in the value of their portfolio. At a horizon of one day the odds of experiencing a loss are about 50:50. The odds don¹t improve much if we extend the horizon to a month. Even at one year the odds of seeing the value of an equity portfolio shrink are about thirty percent. However, if we extend the horizon to ten years, there have been only two periods of ten or more years since 1926 with nominal declines in value (1929 thru 1942 and 1930 thru 1942).
Let us examine how the length of the investment horizon can impact investment results. Behavioralists have noted a tendency for investors to experience what is called myopic loss aversion. The concept of loss aversion, first introduced by Daniel Kahneman and Amos Tversky in 1979, ** refers to the aforementioned tendency for investors to weigh losses more heavily than gains. Myopia refers to a narrowing of the viewfocusing on the most recent, short-term results, even when the investment horizon is long.*** Given the random nature of short-term investment results, investors that check the performance of their portfolios on a daily basis will experience many days of losses. Conversely, the longer the time frame between evaluations the less likely it is that the portfolio will experience losses. Given that investors feel the pain of losses far greater than they feel the joy of gains, they are likely to not only experience disappointment if they check their portfolios with great frequency, but they are more likely to panic and sell, as the pain of losses becomes intolerable.
Behavioralists have used myopic loss aversion as one possible explanation for the answer to what is known in academic circles as the "equity risk premium puzzle." The puzzle is why the equity risk premium has been so large when there have been very few long periods of poor equity performance. The behavioral solution to the puzzle is that the pain of short-term losses is so great that investors demand a large risk premium in order to compensate for the pain they endure in the short term.**** Of course, another solution is a risk related one: equities are very risky and the large risk premium reflects that risk. The large return to investors simply reflects what has been called "the triumph of the optimists" the risk of equities simply has not shown up in the U.S. over the long term. There is of course no guarantee that it will not show up in the future.
How can myopic loss aversion impact investment results? Investors that check on the values of their portfolio with great frequency are more likely to be subject to this ³disease.² And with the advent of the Internet age, most investors now have the capability to check on their portfolio¹s valuation on a daily basis with great ease unfortunately subjecting themselves to the pain of losses with great frequency. This pain, caused by myopic loss aversion, can easily cause them to stray from a well-thought-out investment plan (asset allocation). This is especially true in bear markets when the frequency and intensity of the pain is greatest. Thus investors become susceptible to that dreaded condition known as convex investingbuying high and selling low.
The obvious conclusion that one can draw is that the less frequently individuals observe the performance of their portfolios, the more disciplined, and more successful, they are likely to be as investors. Unfortunately, the Internet age tempts investors with tools that make checking valuations far too easy a task. Investors are best served by going on a "portfolio valuation diet" long periods of fasting, and the longer the better, with a very occasional stop at the dessert tray. The longer the fast, the more likely it is that the dessert will be sweet.
For those interesting in learning more about how human behavior leads to investment mistakes, the first section of my book Rational Investing in Irrational Times, "Understanding and Controlling Human Behavior Is an Important Determinant of Investment Performance," covers thirteen behavioral mistakes investors make. The book provides both the diagnosis and the prescription for the cure. The book also covers another forty-nine investment mistakes even smart people make.
* Sanford Bernstein.
Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," and "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services. Today's Commentary: 05.04.03 The economy has found that even though April unemployment points clearly in the direction of recession, it has not receded. It hasn't recovered either but the simple effort is worth noting. That effort has been a major concern to the F.O.M.C. of late. Next Tuesday, this board meets to determine whether the economy needs a little more in the way of easing, perhaps even a little monetary stimulus. Most of the post-war numbers are in and while we were waiting for the last number of the month, it looked as if everything would remain on course. The interest rate would hold, traders and dealers believed, and the economy would conduct a slow, arduous journey to health.
The second is the 630,000 part time workers who would dearly like full time work. These are not only underemployed, but also under-spenders. Under-spenders tend to take on a wait and see approach to consumption, a technique that forces prices lower creating a deflationary market. Corporations who tout that their business is improving are looking at profitability with incredibly weak sales. Without the ability to place some sort of upward pressure on prices, companies will not be able to grow. Inability to grow means that they will not likely hire many of those workers back. If shareholders are comfortable with that scenario and continually bid stock prices up, then nothing will happen. No interest rate cut. No increase in hiring. No growth of any sizable amount.
The Fed could however help things along with a flood of money into the system instead of the slow systematic method currently employed. Mr. Greenspan fears the worst though and was loath to say anything other than spending discipline is favorable to tax cuts. Could he have meant that the effects of the tax cuts would be counterintuitive to what was intended?
The government is currently the largest employer and a certain amount of spending on their part is needed to sustain those workers. Suppose the government decides to cut their work force as the private sector has, reducing the size of government while the economy flounders. The effects would be devastating. The private sector would have to absorb tens of thousands of workers if as little as one percent of their workforce was laid off. Those could be the numbers that Greenspan and co. are waiting for.
The Week Ahead in Equities
I believe that the investor has developed the attention span of a gnat. Despite all the numbers available, which may or may not apply to the way the economy is shaping up; despite all of the pulpit pounding that writers like me do; the average investor won't remember the last three years when they look back in twenty years. It seems that they are having a difficult time looking back several months.
I tend to believe in numbers... and they always work the way I want them to work. If I am an optimist, I will read only the positive, discard the negative, and believe that hope for the best is all I will need. Unemployment matters not. It simply means that the summer hiring has not begun. It means that businesses are at a low but are unlikely to stay there. In fact, several economist see employment rising in increments of fifty thousand or so month after month for the next year.
If I was a pessimist, I would have no difficulty finding a negative view point to support my poor outlook. The Bush tax cut will have a greater effect on the economy it is trying to save. It will, instead of costing the modest trillion dollar ten year deficit, actually have a price tag of four times that amount. Corporations who generate less revenue pay less taxes. Last year, which is currently being refunded shows that corporate income was down 46%. That is a serious loss of tax base. That leaves less coming in to cut. A pessimist might see the whole notion of the tax cut as bad at any amount.
Perhaps we give investors too much credit for their ability to balance all of the information available. I believe it is called the paradox of assimilated knowledge. The investor has so much information that they are actually ignorant. The recent rally is not sustainable for very long making the next high higher and next low unfortunately, much lower.
The Week Ahead in Bonds
The effect of inflation on real earnings is magnified in the overpriced bond market. The monetary supply, which I suggested should be raised higher than the current 6.3% would not be a bond holders dream situation. Printing paper is never good for a market dependent on the lack of cash to drive yields higher.
And suppose business has no other option but to raise prices and hope for the best. Further rate cuts to help stimulate the marginal profits of stifled markets would only increase the likelihood that inflation would take hold.
And I would be remiss if I didn't mention the effect of the ever increasing (estimates) deficits. The final tally for Iraq is not yet in and we are already counting expenses for this year at $400 billion plus. Add the pressure of a tax cut and you will basically insure that inflation will be with us for a good many years to come.
Treasuries seem the worst hit by this scenario. With inflation at the current rate of 3% and 10 year Treasuries at yields of 3.9%, add in a combination of federal and state taxes, and you are holding something worth less that zero in terms of real return. So what do prudent investors do in this case? Sell. Selling will create a price depreciation and a yield increase.
Now add an interest rate increase, an inevitability should the Bush tax plan pass muster and find its way into the American history books. One percentage point increase in the short term lending rate issued by the Federal Reserve is equal to an 8% decline in value of a 10 year Treasury note, a 14% decline in the 30 year long bond. The scenarios get worse from there with the historical reference pointed directly at the ugly inflationary/interest rate index from 1980-81.
Best bets lay in short term Treasuries and high yield "sterling rated" corporate bonds.
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