Wynn Quon, Globefund.com
Tuesday, December 24, 2002
Assume you are retiring in twenty years. In the meantime you will be saving and investing your money. Now during this period, would you prefer that prices of stocks go up, stay the same or go down? The answer is you want prices to go down. If you’re buying stocks now in anticipation of a long-term retirement, you want to buy cheap! Rising stock prices would only be a good thing if you were selling. (This insightful question was posed by none other than Warren Buffett in one of his eminently readable "Letters to Shareholders". If you’re serious about stock market success, check out his well-written and right-on-the-money wisdom at http://www.berkshirehathaway.com/letters/letters.html.)
When stock prices fall, are risk levels rising or falling? Risk levels are falling. But strangely enough, novice investors and even some seasoned investors behave as though risk levels are rising. In other words, they stop buying.
That’s two big reasons to love bear markets. But if bears are so good for investors why is everyone down-in-the-dumps about the recent market decline? It's because investors put too much of their assets in stocks during the bull market. They overestimated their loss tolerance.
Here’s a little thought experiment. Let’s say you have $500. I am going to toss a coin. If it’s heads you lose your $500. If it’s tails, you win some money from me. How much money would it have to be before you take the bet? If we were risk neutral, you’d take the bet if I were to offer anything over $500 because over time that’s a winning proposition. But according to studies done by researchers the average person wants the win to be $1000 before being willing to risk his $500. In other words, most people feel losses twice as strongly as gains.
If we’re so loss-averse, how do we explain bull markets in the first place? Our loss aversion doesn’t go away during bull markets, it’s just temporarily masked. Other powerful psyhological forces such as "recency" are at work. Recency is the strong emphasis we place on recent events over events in the past. When prices soar during a bull market, we are lulled into believing that they will continue to rise and that losses will be minimal. (Remember the analysts who said that the New Economy made the business cycle obsolete? That was psychology speaking). Unfortunately, bear markets are inevitable and prices can easily fall 30%. In serious cases, such as in 1929, stock prices can collapse.
When a bear market starts, investors get anxious. The anxiety deepens as prices fall. Many investors bow to the pressure to sell. Many more however will hold on. If they bought BCE at $40, they want to "wait for it to come back" before selling. Bear markets are marked by strong feelings of regret. If you’re giving up and thinking of selling BCE at $30 and now it’s $25, you will likely sell if BCE runs back up to $30. The result is that rallies are often short-lived as regretful investors bail out when prices rise. At the end of the major bear market of 1973-74 (when prices fell over 40%), mutual fund outflows actually increased, as investors tried to assuage their regret and their anxiety by selling stocks. That was exactly the wrong thing to do. Is it any wonder that many investors end up with poor results? If you don’t buy low, you can’t sell high.
How can we overcome these psychological pitfalls? I return again to the idea of scenario planning. By setting up and considering the impact of major stock market movements on your portfolio, you shelter yourself from the prevailing psychological winds of the day.
Scenario planning for a bear market is done best when the bull market is raging (and the reverse is true too). We first mentioned scenario planning in our January 2000 column when we strongly suggested that readers consider an imminent stock market decline and how it would affect their portfolios.
Want to confront your bear market worries head-on? Let’s do some extreme scenario planning. In the 1929-32 bear market, stock prices as measured by the Dow Jones Industrials Index plummeted by 90% over three years. If this were to happen today, the Dow would fall to around 1200. Ask yourself, what is the minimum amount of assets that you want intact if this worse-case scenario were to happen? This will tell you what your stock market allocation should be. There’s a school of thought that says that your allocation should be based solely upon your age because younger investors have more time to recover from setbacks than older investors. The problem is this assumes we’re robotically rational and that we can weather severe downdrafts without blinking. This is emphatically not true.
Let’s take a numerical example: A friend of mine has a net worth of $100,000. She would like to invest in stocks but her bottom-line requirement is that no matter what happens in the market, she wants to have a minimum of $50,000 in assets. If she puts around 50% of her assets in bonds and GICs and the rest in index mutual funds, she can meet this requirement. If a 90% drop in stock prices happened, her net worth would be $55,000 ($100,000 - (.9 x $50,000)). An amount which is safely above her $50,000 minimum. In fact, she could raise her allocation to about 55%. By embracing the worst case scenario, she has effectively figured out her ideal stock allocation percentage. If she wants a minimum of $70,000 no matter what, then her stock allocation should be a little higher than 30%. On the other hand if she wants to sacrifice some security for the prospect of long-term growth in the markets then she can raise her allocation to 60% with the understanding that in the worst case, she will have a minimum of $46,000.
Here’s one thing to be careful about. Remember that the
point behind scenario planning is not to predict the future so
much as to ensure that your portfolio will be properly adjusted
for risk through all kinds of stock market weather. We don’t
know that stocks will fall by 90% (although I wouldn’t rule
it out). Clearly if we knew that stocks were going to
fall by 90%, we would sell. But the trouble is that we don’t
know. The great thing about scenario planning though is that once
you’ve adjusted your
portfolio to take in the worst case, you won’t have to ask
that awful question most investors ask too late in a bear market:
"Should I sell?"
Scenario planning puts us on solid psychological ground. It means that we will be in a stronger position to buy when prices fall. We will not experience regret in the same way that others do. We have also made explicit to ourselves our own loss tolerance. We have said to ourselves, let the markets do their worst, we are ready!