Markets are high, the media and some investors fear a fall – are they right?
‘The time to repair the roof is when the sun is shining’
John F. Kennedy – State of the Union Address 11 January 1962
There is lots of comment at present about how far the markets have risen and if we are heading for a correction. The chart below shows the ten years returns from the IA sector averages UK All Companies and 20-60% Shares (what might be called ‘balanced’). These averages show 75% and 50% total returns over ten years including the 2008/09 wobbles.
The media and investors seem to be pessimists – nervous investors may now be seeking guidance about reducing risk, so what does the data show?
Stock markets don’t rise all the time but they do gain most of the time and it generally pays to take the optimistic view, says analysis research from Proinsias O’Mahony.
‘it’s an unarguable fact, however, that stock markets typically rise over time’
“Stock markets do suffer frequent declines, but the long-term trend has always been an upward one. In the United States, equities have historically gained in roughly three out of every four years, and there has never been a 20-year period where stocks lost money.
In the UK, stocks have beaten cash in 68% of two-year periods and 75% of five-year periods, according to Barclays’ annual Equity Gilt Study. Over 10 years, UK stocks beat cash 91% of the time; over 18 years, the beat rate rises to 99%. It’s a similar story with bonds, with stocks outperforming the vast majority of the time.
Things aren’t always rosy, and sceptics can point to disasters like Japan, where stocks have halved in value since 1989’s infamous peak. It’s an unarguable fact, however, that stock markets typically rise over time’.
Eggs in baskets
The figure below shows the returns over the last ten discrete years from 12 IA sectors and an ‘equally weighted’ portfolio of the 12. It clearly shows the benefit of diversifying across a range of asset classes in reducing downside risk.
O’Mahony also notes that journalists have always tended to be more negative about market declines than they are positive about market gains, according to Prof Diego Garcia. His study The Kinks of Financial Journalism examined market coverage in the New York Times and the Wall Street Journal over the last century, and found it had ‘barely changed’ over that time period, with ‘virtually all’ authors ‘emphasising negative returns, ignoring large positive market moves’.
Earlier this year, Financial Times columnist John Authers, one of the most thoughtful commentators in the investment world, admitted his own writing is likely to be similarly biased towards the negative. Firstly, journalists view themselves as sceptical watchdogs, ‘the public’s first line of defence against people in the industry trying to oversell them things’. Secondly, ‘we are far more scared of encouraging readers to buy and ushering them into a loss, than we are of urging them to be cautious, and leading them to miss out on a gain’.
A journalist who tells readers to buy an Enron-like stock would be vilified, said Authers, but no one complains if you tell readers to avoid a stock which goes on to soar in price.
Of course, financial journalists are not the only ones to be guilty of a negativity bias.
Emboldened by the 2008-2009 financial crisis, various ‘perma-bears’ have spent most of the last eight years warning that overvalued equity markets are headed for another crash of epic proportions.
‘perma-bears’ have spent most of the last eight years warning that overvalued equity markets are headed for another crash’
There is a large appetite for apocalyptic commentary, as evidenced by the continued success of doom-laden financial websites such as Zero Hedge and the media attention given to commentators such as Marc ‘Dr Doom’ Faber, who has been warning since 2010 that markets are headed for a 1987-style market crash.
This is an age-old problem. Way back in 1828, John Stuart Mill wrote: ‘I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.’
The same point is noted by influential Harvard psychologist Steven Pinker, author of The Better Angels of our Nature, which cites a mountain of data showing that, contrary to popular belief, human violence has decreased enormously over the centuries. People tend to be wrongly convinced that the world is going downhill, says Pinker, whose reflections on the psychology of pessimism can also be applied to investors.
The main problem is that pessimism is ‘intellectually seductive in a way optimism only wishes it could be’, as Morgan Housel from the New York-based Collaborative Fund noted recently. Studies bear out Housel’s contention that pessimism seems smarter than optimism. One study concluded that people who wrote negative book reviews ‘were perceived as more intelligent, competent, and expert than positive reviewers, even when the content of the positive review was independently judged as being of higher quality and greater forcefulness’. Other studies show when people are asked to impress others with their intelligence, they trot out negative and critical opinions.
Not only are pessimists and critics seen as smarter, they are also seen as more ‘morally engaged’, says Pinker. Consequently, investors may perceive bullish commentators as superficial salesmen while their bearish brethren are mistaken for forthright truth-tellers.
‘pessimism can sound smart, but the history of equity markets suggests optimism pays better’
Thirdly, there is the ‘bad is stronger than good’ effect, as documented by psychologist Roy Baumeister. The pain of a euro lost dwarfs the joy of a euro gained; criticism hurts more than praise encourages; bad information is processed more closely and attentively than good information.
As Baumeister puts it, ‘bad is stronger than good, as a general principle’, which means investors will almost invariably be excessively tuned into the possibility (however remote) of losing money.
These emotional biases towards pessimism are compounded by a cognitive bias, says Pinker, notably the so-called availability bias documented by behavioural finance expert and Nobel laureate Daniel Kahneman. The availability bias refers to our tendency to make judgments about the likelihood of an event based on how easily an example comes to mind. Time in the market and compound interest drive investment returns. However, that’s not news so it doesn’t readily come to mind. On the other hand, it is news when stocks fall 20% in a single day, as they did on Black Monday in October 1987.
That freak event continues to spook investors, many of whom are unaware that stocks nevertheless finished the year slightly higher!
What to do?
The TCF Investment perspective is simple:
- If you can’t afford any loss – keep your money in cash – but beware of the inflation risk!
- Have a plan and understand your attitude to risk and capacity for loss – this is best created with the assistance of a professional financial adviser.
- Align your portfolio to this risk profile and your time horizon.
- Makes sure it is diversified – asset classes, managers and securities
- Rebalance occasionally to keep the portfolio at the risk risk level
- Keep it low cost – ongoing and dealing fees
- Make it tax efficient where possible
- If you are really nervous – drip feed money into your portfolio – this will reduce the risk (and of course the return too).
O’Mahony concludes ‘Investors should take note. Pessimism can sound smart, but the history of equity markets suggests optimism pays better’.
From an original article by Proinsias O’Mahony, The Irish Times