Why Hello There, Volatility
By Brian Aberle
Question: Let’s assume for a second that you had $100,000 to invest and a year later it was worth $200,000, growing steadily each month. Now let’s assume its value had declined to $150,000 just 3 months later. Did you make $50,000 or did you lose $50,000?
First, simple math says that based on the first half of the question you undeniably have $50,000 more than you started with, which would imply a gain, right? That said, the basis of the second half of the question (3 months later) suggests you have also lost $50,000 from your highest level. How you specifically answered depends mostly on your frame of mind at the time, and which piece of the question stirred your emotions the most. For example, did you just find a $20 bill between the couch cushions? You may have answered “I totally made $50K.” Did your iPhone just crash and the earliest available opening at the nearest Apple store (recent experience of mine) is not until next week? Then you may be on the “I’m ticked off that I’ve lost $50K” side of things. Hold onto this thought for a minute.
The timing of this post and thus my question is not accidental. This past week (1/29/2018 – 2/2/2018), the stock market experienced its most significant one-week downturn in over 2 years, with the S&P 500 declining by 4.5%. Monday the 5th made the previous week look like a walk in the park with a 1175-point decline for the Dow Jones Industrial Average in one day, which I’m presuming to be a record single day decline. I haven’t found any evidence just yet, but I’m sure the ironic decline of 666 points on Friday the 2nd (665.75 to be exact) for the Dow Jones Industrial Average is most certainly being discussed in some circles as a sure sign of a coming apocalypse, which I suppose is both humorous and sad as even Satan would know that this is just a numbers game. I digress.
How have these declines felt to you? Did they scare you? Did you pull off to the side of the road during your evening commute to grab the emergency paper bag to breathe into? Did you bust out your calculator to say to yourself “oh great, now I have to work an extra 14 weeks before I can retire?” Maybe you thought to email your advisor and ask if this is the big one or perhaps give him/her a piece of your mind. I speculate you did none of these (give us a call anytime though, just please don’t yell … I’m a sensitive soul), but I’d be willing to bet that more than a few of us went online just to see how bad things were after the past few days. It is human, and not weird. I’ll explain soon.
This recent selloff, if we can call it that, is the first of significance in over 2 years. Statistically, we are still in one of the longest winning streaks in the history of the financial markets and, until Friday’s decline, had been in a cycle of the lowest market volatility (see the steady gains component of my question) in HISTORY! Let that soak in for a minute. Statistically we were living in the “easiest” (from a fear standpoint) period of time ever to be an investor in the markets! Then we were hit with the Devil’s crash (can I trademark that?).
The last major selloff of 10%, which this one is quickly closing in on, was in January of 2016, when oil markets went haywire and essentially crashed, albeit briefly in the grand scheme of things. There was an implied spillover effect at the time that we were told would negate our collective savings. Of course, this did not happen and since that market selloff the S&P 500 has rallied a tidy ~45%, including the recent shorter-term declines. I would argue that for all but the most conservative of investors (to which “investor” is a stretch because investing involves speculation of some kind), gains have generally exceeded expectations over the past couple years.
Let’s go back to the question at the beginning of this post. Did you gain $50K or lose $50K? Do you think some investors feel worse about the 4.5% decline this past week than they feel good about the 41% gains? I believe that some do. What if the 41% gains are “just” 25% gains in 2 months. Still a heck of a good return for the markets over 2 years but, man, it used to be 45%. Or, would we see it as a 30% “loss” versus a decline from the peak?
These emotional games are examples behind the study of behavioral economics, pioneered by Israeli-American Psychologist and Nobel Laureate, Dr. Daniel Kahneman. Over the years, he and many others have tried to figure out what makes us tick when it comes to human rationality and financial decision making, from investing, to consumption, to even insurance underwriting and when to settle legal claims. It is why we drive 5 extra miles to save a nickel on a gallon of gas, and why we (ok, I) only play the lottery when the jackpot is north of $400 million, even though my odds are the same as if I were to be sad to only win $200 million. It’s also why there is a microsecond tinge of disappointment when I play and don’t win the Powerball, akin to when 50% gains are now only 45% gains in the stock market. Granted, losing $2 isn’t that big of a deal.
One of the theories developed by Dr. Kahneman was that of Decision Theory, in which investors have a higher tendency to want to avoid losses than to acquire equivalent gains; that losses in portfolios are psychologically twice as painful as equal gains make us feel good. This explains why, for some, a decline of $50K from the proposed question above would feel far worse than a gain of $50K would feel good. It is hard, even for the most seasoned and battle hardened of us, to place losses and gains on equal footing. This is why market gains tend to be more gradual while losses tend to be more forceful and short-lived. People respond to market losses with quicker action to try and avoid even further decline. Our minds tell us to “just relax” while our hearts say, “I can’t take the stress!”
You can check out Dr. Kahneman’s Wiki page below. Enjoy the rabbit hole.
A YouTube video interview of Dr. Kahneman can be found below:
As investors, there is a fragile balance between our perceived attitude towards risk and our willingness, either emotionally or literally (financial capacity), to absorb said risk. With current markets, given historically low volatility, there are signs of excess risk-taking, whether it be the re-inflating of housing prices, to 1800% jumps (and 50% declines a month later) in crypto currencies, to even one’s eagerness to bid up the price of a stock for every penny of earnings per share. This excess is part and parcel due to the perceived lack of downside risk and that many of us tend to have horrible long-term memories. The waters, or in this case the markets, have been calm for so long that nearly everyone (it seems) has forgone tipping their toes versus doing a cannonball into the risk pool. I’ve seen this more than a few times. Will it end differently? Probably not. When will it end? No idea.
Now that we have the fun stuff out of the way, the current markets present a perfect opportunity to have both an internal conversation (write it out) or an external conversation with your advisor or family about potential risks. Have you been living too richly on your retirement funds? Have you been saving enough to get you to retirement, or are you just coasting because of outsized gains? Now is the time to assess those concerns, not when markets decide to revert to the mean, which I can all but promise will happen.
From our vantage point, we aim to address risks by rebalancing our clients’ portfolios on a regular basis (but not excessively so) while looking to find a balance between long-term core portfolio allocations versus that of shorter-term more tactical allocations. We conduct portfolio stress testing on a regular basis to try and intentionally find holes in our logic and share these outcomes with our clients. If clients have fears that we can test, we’ll gladly work with them to do that too. For our clients, we encourage everyone to have a financial plan so that we can more effectively measure how one is “doing” versus goals. This way, together we can better tell if a stock market decline of 20% is a blip in the grand plan or one that would inflict some long-term damage.
This past week, volatility sent us a message that said, “I’m still here and I’ll be home soon.” Normal will someday make a comeback, and to get to normal from current risk levels, some shared pain will need to ensue. Now is the time to ask yourself the question of the day: how do you plan to cope with it? Now is also a great time to reach out to your current advisory firm to discuss these “what if’s.” Your advisor should have a plan. If not, we look forward to hearing from you.
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