A tale of two risks (excerpt)On the Trading DeskSM—
By Peter Nulty
Market and behavior risks can have a significant impact on an investor’s nest egg. James P. Lauder, portfolio manager and CEO with Global Index Advisors, explains in this excerpt of the On the Trading DeskSM podcast from Friday, December 14, 2012.
Jim, market and behavior risks: What ties these two together?
Sure, Peter. Most all of us are very familiar, unfortunately, with market risk, large downside swings or losses due to market fluctuations— economic principles. Combine economics with psychology, you get what’s broadly referred to as behavioral finance. As investors, as emotional creatures, we tend to focus on short-term decisions based on those emotions rather than long-term outcomes. Loss aversion, plus the anxiety that comes from those market losses in our account balances, can trigger some investors to abandon their investment strategy at absolutely the wrong time and lock in those losses.
“Loss aversion.” What does that mean?
The science behind behavioral finance shows that we actually place about a two-to-one emotional preference on a loss versus a gain of the same amount. So we are twice as emotional about losing ten dollars as we are about the possibility of gaining ten dollars.
Can you illustrate how investors have lost out based on their behavior?
Examine investor inflows and outflows compared to the market returns over time. Go back to 1995 and onward. Market returns go up through the late ‘90s, then, you’d see that correction, the tech bubble burst in 2000, and the market goes down about 45%. All of a sudden, it starts to recover in 2003 and it goes up until we have the Great Recession and the real estate burst in late 2007, and the market goes down. Think about a big curve, like a radio wave, over that period of time. In an ideal world, we would see investors putting in their investments when the markets are up and when the markets are down. In reality these flows from investors actually look a lot like that same curve. It goes up, down, up again, and then down. If you layer those flows on top of those market returns, it’s shifted to the right a few clicks. What that means is that you have investors chasing returns. When the market turns, they continue to invest. But they also start to pull their money out at the very bottom. They’re basically doing the opposite that we would like. They’re buying high and selling low. That has a significant impact on their ability to accumulate capital over time. What we’d like to see is nice steady cash flows.
In dollars and cents, is it possible to get an idea of how these types of bad decisions can impact an investor’s nest egg?
Let’s look back from 1980 to the present. And let’s look at how missing just a few of the best months would impact your nest egg. Let’s assume you invested $10,000 in the S&P 500 beginning in 1980 and followed that through the end of, say, 2011. If you would have stayed invested that whole time and just ridden every storm that we’ve had since then, you’d have had an annualized return of a little over 11%. If you had done any market timing at all, panicked at the bottom and missed the five best months out of that 31-year period, your average return goes down to 9.12. The impact on your balance goes from about $287,000 down to about $163,000. That’s a 43% loss in your nest egg, a huge impact. Now, if you missed more than five months, let’s say that you missed 15 months—that’s only 4% of the months in that entire time frame—you would have lost about 77% of your potential nest egg.
How does a money manager, in the role he or she plays, affect how investors behave?
What we can do is design products that incorporate not just the investment theories, but also behavioral finance theories. Most importantly design glide paths—the manager’s definition of how they reduce risk over time—that are less likely to expose investors to losses of a magnitude that would trigger those self-defeating behaviors and have them lock in those losses. Be a bit more conservative close to retirement; take a fiducially sound approach to mitigate those big downside events. And the money manager has a consistent buying discipline, not chasing asset classes, and not changing their glide path over time to chase returns.
Jim, how can all of this encourage a better outcome for investors?
What I would reiterate from today’s discussion is that by leveraging a more conservative, more fiducially sound glide path, by avoiding those large losses, and by keeping investors invested, we’re going to further mitigate those behaviors, and, keep more people on a path to hitting that point of retirement readiness.
Jim thanks again for joining us here On the Trading Desk.
Thanks for having me and happy holidays to you and all your listeners.
The views expressed are as of 12-19-12 and are those of Peter Nulty, James P. Lauder, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.