A PDF version of this commentary can be downloaded here.

Special Announcements

If you missed our monthly strategy review webinar last week, you can catch the replay here.

The topics covered were:

  • Education: How Tactical Can Improve Your Retirement Odds
  • Strategy Outlook: Risk Managed U.S. Sectors
  • Strategy Outlook: Multi-Asset Income

Market Thoughts

In our opinion, for all the wonderful benefits of the information era, a major downside has been the need to provide constant coverage: the need for a constant and immediate explanation for everything. Lately, day-to-day market commentary has been absurd. Here’s one I heard recently: “the market is up today because the market was down yesterday, which means rates are less likely to go up tomorrow.”

I’m kidding, of course – but I doubt you would have been very surprised if I wasn’t.

While I generally think daily commentary on why markets moved one way or another is absurd, I wouldn’t mind it so much if I didn’t also feel it was downright harmful to investors.

Because, as it turns out, the more frequently investors monitor their portfolios, the more risky they perceive investing to be.  Why?

The first reason is behavioral. Investors are loss averse: they tend to feel more pain from losing $100 than they do from gaining it. Some studies have gone so far as to say investors feel the pain of losses twice as much as the pleasure of gains.

The second reason is statistical. If we model annual returns as a normal distribution, we can find daily, weekly, monthly and quarterly return distributions by scaling expected returns and volatility. However, the twist is that expected returns scale linearly while volatility scales with the square-root of time. This is often why people consider stocks to be less risky the longer the holding period.

We can demonstrate this with a simple example. If we assume an annual expected return of 7% and a volatility of 12%, we can back out that the probability of having a negative return for the year is 28%. But we can also find expected returns and volatilities for daily, weekly, monthly, and quarterly holding periods – and then find the probability of seeing negative returns over those periods.

Figure 1 - 2015-06-22

What we see is that if we check our portfolio daily, there is a 49% chance of seeing a negative return. If we check it annually, however, there is less than a 30% chance.

So if we combine this with the fact that we feel losses twice as much as we feel gains, then checking our portfolio on a daily basis will likely not only cause us to believe markets are riskier than they really are, but will likely put us in a depressive state. The fact that the perception of riskiness seems to increase with the frequency of portfolio evaluation is known as myopic loss aversion.

Advisors we’ve spoken to lately have mentioned a significant uptick in client concern. For clients reading the headlines, it seems like a new crisis every day. Most recently, “will Greece default?”, “is China in a bubble?,” and “will an increase in the Federal funds rate cause catastrophic bond losses?” And that’s just the first half of 2015. Perception is a powerful thing. For those that have just started tuning in recently, it seems like the market has never been riskier.

For those of us that evaluate markets professionally, we recognize that every year is filled with these “almost crises” – and most can be safely ignored. Why? Because the headlines are vastly oversimplified summaries of incredibly complex and nuanced topics, designed to prey on our behavioral biases and sell more newspapers.

Most investors would likely be better off simply tuning out.

But asking that of investors is also not realistic.

So we cannot ignore the very real behavioral aspects of investing, as it may be the biggest hurdle investors face when trying to achieve their long-term goals.

That’s why we believe in providing tactically risk-managed investment strategies built on an objective, rule-based framework. For investors that only tune in sporadically, the market can seem like a dangerous place. But knowing that there is a defined process whereby their portfolio seeks to minimize significant losses can go a long way in helping them avoid irrational short-term decisions – and that may be the biggest benefit of all.
