- Don’t lose your sense of history – The average intrayear drawdown over the past 35 years has been just over 14%. The market ended the year higher on 27 of those 35 years. A relatively placid six years has lulled investors into a false reality, but nothing that we have experienced this year is out of the ordinary by historical measures.
- Don’t equate risk with volatility – Repeat after me, “volatility does not equal risk.” Risk is the likelihood that you will not have the money you need at the time you need it to live the life you want to live. Nothing more, nothing less. Paper losses are not “risk” and neither are the gyrations of a volatile market.
- Don’t focus on the minute to minute – Despite the enormous wealth creating power of the market, looking at it too closely can be terrifying. A daily look at portfolio values means you see a loss 46.7% of the time, whereas a yearly look shows a loss a mere 27.6% of the time.Limited looking leads to increased feelings of security and improved decision-making.
- Don’t forget how markets work – Do you know why stocks outperform other asset classes by about 5% on a volatility-adjusted basis? Because they can be scary at times, that’s why! Long term investors have been handsomely rewarded by equity markets, but those rewards come at the price of bravery during periods short-term uncertainty. The relationship between risk and reward is real; choose peace of mind or a shot at meaningful wealth-compounding because you can't have both.
- Don’t give in to action bias – At most times and in most situations, increased effort leads to improved outcomes. Want to lose weight? Start running! Want to learn a new skill set? Go back to school. Investing is that rare world where doing less actually gets you more. James O’Shaughnessy of “What Works on Wall Street” fame relates an illustrative story of a study done at Fidelity. When they surveyed their accounts to see which had done best, they uncovered something counterintuitive. The best-performing accounts were those that had been forgotten entirely.In the immortal words of Jack Bogle, “don’t do something, just stand there!”
Ancient Grecians believed in geocentricity, the idea that the Earth is the center of the Universe around which all others objects orbit. In classical antiquity, it was widely supposed that the body contained four humors, blood, black bile, yellow bile and phlegm, and that optimal health resulted from an appropriate balance of the four. Maternal Impressionists explained birth defects in children as resulting from negative thoughts from the mother during pregnancy. And phrenology, the practice of making inferences about someone’s character and personality from the shape and contour of their head, was for some time thought to be a legitimate science.
Much as we laugh at these pseudo-scientific anachronisms, I am confident that the time is not far distant that we will puzzle that we ever developed financial models that did not somehow seek to account for the behavior of market participants. In making such a provocative statement, I do not wish to pick on traditional financial models or necessarily to elevate what currently constitutes the burgeoning field of behavioral finance. Rather, I hope to illuminate the ways in which arriving at any sort of truth is an imperfect endeavor and discuss the way in which ideas that begin on the lunatic fringe can sometimes be welcomed into the fold of legitimate scientific inquiry.
Almost since its inception and increasingly with its popularization, proponents of behavioral finance have delighted in dismantling the efficient market machine, gleefully poking holes in this dogma with quirky anecdotes about investor irrationality. For their part, efficient market theorists have given as good as they’ve gotten, criticizing behavioral finance for its lack of theoretical underpinning and inability to consistently improve investment returns. But all of this rhetorical jousting (while fun!), misses the point fundamentally.
Rather than hoping for the death or preeminence of one faction or the other, we ought to be working to combine the findings of both camps in applied ways that positively impacts actual investors, something Dr. Greg Davies calls “behavioralizing finance.” Behavioral finance has a great deal to learn from efficient market theorists about building a comprehensive, rigorous framework of assumptions. Traditional finance could learn a thing or two from the behaviorists about being tentative, respecting the limits of knowledge and safeguarding others’ assets accordingly.
Behavioral finance was born in the ivory tower of academia, legitimized with Daniel Kahneman’s Nobel Prize, popularized by Dan Ariely, Richard Thaler and others who taught us to laugh at and recognize our own financial misbehavior. Oddly enough, the next step in the progression of behavioral finance is an anonymity of sorts, the kind that comes with widespread acceptance and integration. After all, heliocentrism is not an idea anymore, it’s the “way things are.”
My children are six and two and it is my hope that when they attend college there will be no behavioral finance courses offered at their universities. If there are, we will still be mired in the same intellectual turf wars that can keep great ideas from exploring their points of fusion rather than their surface dissimilarities. My hope instead is that they will learn about finance, a complicated, tentative, somewhat messy discipline that their professors approach with some mathematical precision, but would never dream of disconnecting from the people that give it life.