See how you can play better in the market for the rest of 2022: Do not look.
I offer this advice not because I believe the bear market will continue – although of course it could. I would offer the same advice if I thought the next part of the uptrend was about to start.
The reason you do not look is that “appearing” is not a benign act. It actually changes your behavior – often in destructive ways.
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It prompted me to make this observation from a fascinating recent study that has begun to circulate in academia. The study, “Unpacking the Rise in Alternatives,” was conducted by Stanford’s Juliane Begenau and Harvard’s Pauline Liang and Emil Siriwardane. This study focuses on a relatively obscure feature of the investment industry – the large increase over the last two decades in the distribution of the average pension fund to so-called alternative investments such as hedge funds and private equity. But what the researchers found has implications for all of us.
Applying a series of complex statistical tests, they concluded that an important determining factor in the decision of a given pension fund to establish an allocation to alternative investments was whether but pension funds in the same geographical area did the same. In other words, if a pension fund in a given area started a significant allocation to alternative investments, then the chances of others nearby doing so increased.
Good pressure from peers, in other words. Both for the independent analysis supposedly conducted by the expensive analysts and consultants working in the pension funds.
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The reason this is relevant to all of us: If these investment experts are not able to think independently, it is even less likely that any of us will be able to do so. And that can be costly. To be opposed, for example, to mention only one well-considered strategy, requires to go against the consensus. To the extent that we constantly look over our shoulders to see what others are doing, then being the true opposite becomes even more difficult than it already is.
I remember the classic remark by the late British economist and philosopher John Maynard Keynes: We would rather “fail conventionally than succeed unconventionally”.
Myopic aversion to loss
Peer pressure is just one of the reasons we need to reduce the frequency with which we focus on short-term market rotations and the course of our portfolios. Another important one is known as Myopic Loss Aversion (MLA).
The MLA exists for two reasons. First, we hate losses more than we love profits, and it is difficult to resist controlling the performance of our portfolios. Consequently, when we check the net worth of our portfolio more often, we will have higher subjective perceptions of risk. This in turn translates into a lower spread on more risky investments – the ones that usually produce the highest long-term returns.
The discovery of MLA traces in research in the early 1990s by Shlomo Benartzi, professor and chair of the Behavioral Decision Making Team at the UCLA Anderson School of Management, and Richard Thaler, professor of Behavioral Science and Economics at the University of Chicago Booth School of Business (and winner of the Nobel Prize in Finance 2015). Since then the existence of MLA has been confirmed by numerous studies.
One of the most characteristic compared the performance of professional traders to two different groups: those who focused on the performance of their portfolio per second and those who checked every four hours. Those in the latter group “invest 33% more in risky assets, making profits that are 53% higher than traders who frequently receive price information,” the study found.
I doubt if any of you check the status of your portfolio every second of the trading day, even though I know some of you are about to do so. But the study makes the general pattern clear.
To use an example more relevant to the typical retail investor, imagine Rip van Winkle sleeping at the beginning of last year, 18 months ago, controlling the SPX of the S&P 500,
level just before bedtime. If he woke up today and controlled the market, he would probably yawn and go back to sleep. In terms of price alone, the S&P 500 has gained 1.1% since the beginning of last year and 3.3% in terms of overall performance.
On the contrary, if Rip Van Winkel woke up every month and checked his portfolio, he would now be nauseous. The S&P 500 recorded a total return of 5.9% in its best month since the beginning of 2021 and lost 9.0% in its worst month.
Rip Van Winkle’s illustration is not as hypothetical as you might otherwise think. In 2010, Israel enacted a regulatory change that barred mutual fund companies from reporting returns for any period of less than 12 months. Prior to this change, one month returns were prominently reported in customer statements. A 2017 study by Maya Shaton, an economist in the Federal Reserve’s Banking and Financial Analysis Division, found that the regulatory change “caused a reduction in the sensitivity of cash flows to past returns, a reduction in trading volume and an increased breakdown in venture capital. “
“I do not look” may not be realistic…
However, avoiding your eyes from the market and your brokerage statement can cost you a lot, especially given the recent exceptional market volatility and the almost saturated coverage of this volatility in the financial press. If this is the case for you, then you need to figure out how to stay disciplined with your pre-determined financial plan, while following short-term market fluctuations.
How it looks in your particular case will depend on your personality. It may require you to hand over the day-to-day control of your portfolio to an investment advisor, who is instructed to never deviate from your predetermined financial plan. Another option would be to invest only in mutual funds that limit how often you can trade. Another would be to work with your brokerage firm, sponsor or consultant IRA or 401 (k) to reduce the frequency with which they report your performance and increase the length of time they report your performance.
As you think about what will be required, it is useful to remember what Odysseus did in Greek myth so that you can listen to the beautiful song of the Sirens. He knew he would not be able to resist their seductive songs, but he also knew that succumbing to this temptation would be fatal. So he had his men tie him to the mast of the ship on which he was sailing so that he could hear. Our job is to find the modern equivalent of tying to the web.
Mark Hulbert is a regular contributor to MarketWatch. Hulbert Ratings monitors investment prospectuses that pay a fixed fee for auditing. You can contact him at email@example.com.