Monthly Archives: June 2013

Fear of Uncertainty

Editor’s note:  Today’s offering comes from the nimble minds of my firm’s summer interns, Linda and Gautam, who I think captured well the spirit and intent of “Persuasion Time.”

In pursuit of certainty we often find that the fear of uncertainty drives our actions. These actions may not be beneficial but they probably feel safe. First year college students face the ever-present threat of not fitting in while retail investors wake up fearing a red negative sign at the bottom of their screen. Acting on these negative urges often results in hastily made decisions that may prove damaging in the long run. The recent market woes prompted us to recall our early days in college, however it is our positive experience thereafter that we hope will encourage long-term participation in the market.

In recent news, hearing and reading about a market that is quickly losing confidence is tough to avoid. When the Fed announced its plan to slow stimulus, investors realized interest rates were poised to rise and took this as a disconcerting sign, instead of realizing the Fed’s nod at a recovering economy. This announcement caused the markets to tumble almost 2.5% in one day. In addition, the recent news out of China   only increased investors’ fear of the uncertainty this bodes for U.S. markets. This led to a three percent slide in the S&P500 over the past week. Akin to the recent market downturn due to global factors, fear of what new trouble tomorrow could bring instilled a negative attitude in us during our early days in college.

(Gautam) As a First Year student at the University, the prospect of finding a group of friends, my niche, was daunting at first. The activities fair seemed like a promising start, but I was met with hundreds of clubs and societies to explore, with no guarantee of an enjoyable experience. It would have been easy to gather my belongings and return to my dorm before even getting my feet wet – something I suspect many people will be doing this weekend at the beach. My increasingly negative sentiment towards not only my peers but also my University was substantiated on my perception of their college experience. It seemed as though everyone around me was “fitting in” – either loving their classes or loving their friends, whereas I felt neither. In order to avoid perpetual unhappiness or future regret of inaction, I chose to begin applying to other institutions to escape.  Which in hindsight, was just like retail investors selling stocks when they go down…

(Linda) Arriving to the States as an international student from Switzerland to study at the University seemed extremely exciting at first. Although I had never visited the University, all the stories I had heard and pictures I had seen contributed to the high expectations I developed, but only became aware of after arriving. The first few weeks were thrilling with all the “newness” of being a “First Year.” While I thoroughly enjoyed my classes, I soon started to resent many other aspects of college life in the U.S. Being from Europe, I felt extremely restricted living on a campus far outside a city with limited availability of public transportation. Fellow students were met easily and initial friendships started fast. Nevertheless, in this foreign country without any family I was missing a true friend. Midway through my first semester I started applying to other colleges. I strongly felt that my unhappiness would only get worse and if I did not change something about my situation soon, I would regret my entire college experience.  Again, displaying the “flight” response many retail investors feel at the first sign of market losses.

Both of our first year experiences prompted us to consider transferring to a different University. Scared by initial hardships, we doubted our future happiness and success at this institution.

(Gautam) In the wake of external factors influencing your short-run predictions, it is important to hold your ground and prepare for the long run. It has been two years since I decided not to submit my applications to transfer, and I can now say more good things about my University experience than bad. I have found a group of friends I know I can rely on, and my course of study is even more interesting and challenging than I could have ever imagined.

(Linda) In the end, I did not transfer. I was unhappy for almost my entire first year. I was scared of the future’s uncertainty, but decided to stick it out. After that one tough year, I started genuinely having an amazing time, found great friends and am now experiencing the unforgettable college life everyone has talked to me about before coming to the States.

The fear of uncertainty about the future seems to be an ever-present feeling for investors. Equity investing seems exciting when we start creating our first portfolio. We eagerly wait for stock prices to rise and make returns. Once the market shows signs of a downturn, however, fear takes hold of the investor and selling the stocks whose prices are rapidly falling seems like the only possibility in order to avoid great losses.

In the short run the market will always be volatile (downwards as well as upwards!). Trying to predict the market and timing short- term trends are characteristics of gambling. Given that all available information may be priced into stocks, it is extremely difficult to “outsmart the market”. If the investor stays in for the long run and does not sell equities as soon as the market struggles, attractive long-term returns can be expected. Sticking with one’s choices and not being scared off by negative developments is crucial not only for investing, but for life in general. Much like the long-term return our University provided, the stock market depicts a similar pattern. Negative shocks have rattled markets and investors for decades, however overtime a positive return has been the result.  Stocks also outperform all other assets classes in the long run.

Expectation: Correction

In a previous incarnation I was an equity market strategist.  The equity strategist helps investors make money in the market by analyzing the macro environment, making predictions and writing insightful market commentary.  The most visible output for the equity strategist is the market price target.  Yes, most equity strategists are required by custom (if not by job description) to publish price targets for the market.  Looking around Wall Street, one can easily find the published price targets for the major strategists.  Given how difficult it is to make predictions (especially about the future, as Will Rogers famously quipped), one could assume that being an equity strategist is a tough job.  It is.  But let me fill you on a few details that may demystify the position a bit.

The first “secret” to making forecasts as an equity strategist is to never predict both level and time frame.   “I predict that the Dow Jones Industrial Average will reach 16,000” is a fine forecast (in fact I was making that “prediction” internally in February 2012).  “I think the market will rise to the end of the year” is another fine forecast.  The first one defines level, but not time frame; the second time frame but not level.  Both of these allow some “wiggle room” for the strategist.  Predicting both level and time frame increases the odds of being wrong by 100%.  Now the goal of these forecasts is not just to allow the strategist to weasel out of a more useful forecast, but being “right” isn’t really the main goal of the strategist.  [This is a broad generalization and some equity strategists may really try hard to be “right” all the time, but I think they would be in the minority.  Forecasting correctly is a very, very difficult exercise.]

Take the case of a wonderful market strategist I worked with the in 1980s.  He made a very convincing and well-thought out bull case for U.S. stocks in the mid-1980s.  The crux of his thesis centered on demographics – the baby boomers would be reaching their peak earnings during the decade and this bulge in earnings would lead to buying stocks and a strong equity market. Turns out he was absolutely right.  Yet he was fired from his job within two years of making this bold and ultimately “correct” forecast.  What happened?  He couldn’t find much to say beyond this one call based on demographics.  Our clients did not find much value in his work. Clearly, being “right” wasn’t enough for this fine fellow.

This leads to the second “secret.”  Another strategist told me this secret a few decades later.  This fellow was well-liked by clients, but by my assessment of his work, he seemed only slightly above average.  I once asked him why he was so popular with our clients.  He told me that the key to his success was to visit and call clients frequently (this is why it’s called the “sell side”) and tell them one thing they did not know.  Thus his key to success was not to be “right” all the time (or really any of the time – that’s wasn’t why clients liked him), but was to provide our important hedge fund and mutual funds clients (grizzled veterans usually) with one meaningful data point each visit or call. Given how much our clients knew about everything, this was a challenge, but one that could be met by the most successful equity strategists.

This lengthy preamble leads us to the topic of the day.  If I were an equity strategist and had to make a prediction right now I would say “I think the market is likely to make a correction.”  Note how there is no time frame for this forecast.  Why would I be tempted to make this prediction now?  First, corrections of up to 10% within the context of a bull markets are normal and natural.  They represent a type of safety valve to prevent the market from becoming too frothy, too speculative or too overvalued.  Second, the recent history of the market shows summertime corrections are the norm. We’ve experienced sizable corrections in each of the past three years.  Could it happen again this year?  Why not?

What is the “proper” thing to do in a correction?  First, don’t sell.  Selling in anticipation of falling prices is a risky proposition.  Selling this way forces the investor to make a second timing decision of when to get back in the market.  As the market corrects most people feel less willing to buy stocks even though they are cheaper.  Second, buy on weakness.  If an investor has some “excess” cash hanging around, using a correction to increase one’s equity exposure might make some sense (of course, accounting for each investor’s long-term asset allocation and risk tolerance).

So to recap- don’t sell, but consider buying on weakness if a correction happens.  If there is no correction, then all who are fully invested can simply carry on their merry way.  Those who are still holding lots of cash waiting for “things to settle down” may be in for an even longer wait…

California Screamin’

I am not a big fan of roller coasters.  Perhaps it’s my age.  Maybe it’s the meaningful volatility I face each day in the capital markets.  Whatever the reason, I am not a big fan of roller coasters.

Imagine my family’s surprise then, when I agreed to join them on the “California Screamin’” coaster in Disneyland.  As you can see in the picture above, this roller coaster is not the most extreme coaster in the world, but it is well above my comfort level.  So why did I agree to this self-inflicted terror?

It was simple misunderstanding.  At the entrance of the ride there appeared to be two rides: one small, non-scary looking thing and the other big, scary “California Screamin’.”  I truly thought we were going on the smaller ride, until we got on board.  The ride began with a massive acceleration followed by a rather high peak and subsequent plunge.  At this point, I knew I was in big trouble, because up ahead I saw the big peak of the ride.  Did I mention that I’m not a big fan of high places either?

So faced with this double whammy of phobias I did what I always do to combat stress, I began generating alpha waves.  In college I underwent some biofeedback training and learned how to generate alpha waves to improve my meditation skills and to deal with stress.  So, as I approached the apex of Mickey’s torture machine, my eyes were lightly closed, my breath deep and smooth and my face of picture of meditative serenity.

The rest of the ride was inconsequential.  I recall many loops and twists, ups and downs; we even went upside down at one point.  All the while, my little brain just kept on pumping out those alpha waves.  At this point, the reader might be wondering if this is some kind of “Tall Tale” with a jokey punch line.  I assure you, it is not.

At the end of the ride, a camera snapped a picture of our family as we neared the end of the ride. My wife looks like she’s having the time of her life – hair blowing in the wind with a huge smile on her beautiful face.  Behind us are Ben, whose eyes and mouth are wide open in mock terror (like his dad, he is a big fan of irony) and Matt, whose face is all scrunched up from laughter.  He too looks like he’s having the big time ever.  Then there’s me.  Face calm, lips pursed into a slight, knowing smile, eyes peering steadily into the camera as if to say “Ha ha – you did not scare me!”  [Disney copyright rules prevented me from sharing the photo, but trust me – it is a classic]

So what does this have to do with investing?  For one, I think I now understand why I can maintain a reasonably stoic demeanor in the face of market volatility.  Back in 2008-2009 when everyone seemed to be panicking, I was able to provide perspective, comfort and useful advice to our clients and my colleagues.  I may not have been aware that I was using biofeedback to maintain my composure during those challenging days, but I guess I was.

Second, amusement park ride volatility is by design fun (for most), but capital market volatility is fun for no one.  We like a good scare every now and then, whether it be at a horror flick or a roller coaster ride, and this is probably healthy and cathartic.  Being afraid that you will not be able afford retirement due to market volatility is a scare no one should have to face.  In my view, market volatility in and of itself is not that damaging (no fun, clearly); it is our response to it that can have lasting effects to our detriment.

Selling at the bottom and buying at the top are two strategies guaranteed to reduce one’s ability to reach long-term financial goals.  We saw a lot of selling in late 2008 and early 2009.  Some of those people may still be hoarding cash either waiting for a pullback or some other signal that “all is clear.”  Now, we are hearing about a lot of people wanting to increase equity exposure.  I have no idea whether we are close to the peak or not, but I do know that increasing one’s equity weighting based on how one feels about the market is probably an unwise move.  Asset allocation, in my view, should reflect the intersection of one’s risk tolerance and need for portfolio growth, not one’s views on the stock and bond market.  Changing one’s asset allocation based on feelings may be recipe for selling low and buying high.

For the record, I am still fully invested in equities and am still able to find individual stocks which seem substantially undervalued relative to my estimation of fair value.