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• Fight or Flight-Should I Stay in the Market or Run and Hide

Fight or Flight... Should I Stay in the Market or Run and Hide?

written on March 15, 2011 by Frank Fantozzi

 

As history attests, the reason man still exists today is due to our great survival skills. There is a part of our brain that tells us when to fight and when to run. Think about the cave man who confronts a saber tooth tiger or a more modern situation, like a car careening down a sidewalk toward you. Our instincts take over when our lives are threatened.

 However, as modern science has proven, this same part of our brain that deals with life threatening risks is the same part of the brain that governs our reactions to market risk. Does this help investors make better decisions or not?

I’ve read study after study concluding that investors from all walks of life and varying education levels consistently underperform average investment returns. Could it be due to limited access to research or poor research capabilities?  We know it’s not lack of intelligence. So maybe it’s something more basic such as the investors’ ability to handle risk that endangers their investment portfolio. The example below may prove enlightening.

Prospect Theory:

Study Group 1: You have $1,000 and you must pick one of the following choices:

A: 100% chance of gaining $500
B: 50% chance of gaining $1,000, or 50% chance of gaining $0

Study Group 2: You have $2,000 and you must pick one of the following choices:

A: 100% chance of losing $500
B: 50% chance of losing $1,000, or 50% chance of losing $0

Typical results from various groups

	Study One	Study Two
Choice A	Sure gain- 1500, Average Resonse is 80%	Sure gain- 1,500, Average Response is 20%
Choice B	50/50 Chance of 1,00 or 2,000, Average Response is 20%	50/50 Chance of $1,000 or $2,000, Average Response is 80%

While the financial outcomes are the same for the investors in both study groups, the prospect of losing (pain) a dollar is more painful than the prospect (pleasure) of a dollar gain.  It is much more important to maintain what they have than to get great returns. That is why most investors would consistently select “avoid losing money.”  How does this translate in regards to investors staying the course where investment strategies are concerned?

When it comes to the prospect of losing money our brains trigger the same reaction that it would if we found ourselves face-to-face with a saber tooth tiger, we flee. So how do we train ourselves to get past this when studies indicate that approximately 80% of investors make financial decisions emotionally?  

One of the most rudimentary assumptions is that people are rational wealth maximizers who seek to increase their own well-being. In most cases this assumption does not reflect how people behave in the real world. Types of irrational behavior: loss aversion, overconfidence, gamblers fallacy, mental accounting and herd mentality drive most investment decisions.

When the market goes down, investors sell. The exact opposite of what logic dictates. This is confirmed consistently when we look at money flow trends. If you look at historic market bottoms, you consistently see large outflows in the equity markets. The logical investor would invest in the market at this point (buy low, sell high), yet historic data proves otherwise.

It’s the classic prospect theory versus prudent investor theory. When do investors return to the equity markets?  When they begin to feel good about the market. When do they begin to feel good about the market again? When everyone else jumps back in, pushing up prices. It doesn’t make sense to invest when prices are rising or at their peak.

Have you ever bought a lottery ticket? The odds are roughly 146 million to 1. Not in your favor. It’s the hope of winning that drives us, but hope is not a strategy.

Fidelity Investments performed a study many years ago when Peter Lynch ran the well know Magellan Fund. In only one of the 10 year periods that Lynch managed the fund its average return was in the 20% range. The average investor in the fund received a return in the 10% range. Why? Because investor dollars flooded the fund at its peak performance. Everybody wanted a piece of the top-performing Magellan Fund.

Someone once asked me what the most difficult part of my job is. I said it’s helping my clients manage their emotions. It’s important to understanding that people are looking for answers in an investment world filled at any given time with anger, fear, euphoria, confusion, feeling lost or simply apathetic.

The following three risk parameters address the emotions people bring to their investment decisions:

1. Risk tolerance (physiological)…How much risk you prefer to avoid
2. Risk Capacity (financial)…How much you cannot afford to lose 
3. Risk required (financial)…How much risk you may need to take to reach your goal

Helping clients align these risk parameters is vital to helping them staying the course in periods of uncertainty. In 1952 Harry Markowitz published his landmark study in the Journal of Finance on Modern Portfolio Theory and the Efficient Frontier. The study basically states that by maintaining a diversified portfolio, a great deal of risk can be mitigated.

While this sounds simple, logical and rational, many investors allow emotional behavior get in the way of sound financial decisions. But there is a cure and it doesn’t involve brain surgery.

First, be honest with yourself. If you find yourself making financial and investment decisions based on your emotions, fear in particular, acknowledge that. Then consider hiring an advisor who understands you, your concerns, fears and risk tolerance. Once you’ve established those parameters, your advisor can act in the capacity of the emotionally disinterested partner in the relationship who will apply logic and discipline to your investment decisions. This can go a long way toward helping you stay the course and potentially reap rewards as a result of your more disciplined strategy.