Easing the Pain and Enjoying the Ride

In 1979 Daniel Kahneman and Amos Tversky, who are widely recognized as the pioneers of the field of behavioral finance presented a concept called prospect theory which has gained widespread acceptance over the years. One of the key tenets of prospect theory is that people tend to value gains and losses quite differently from one another. Specifically, prospect theory suggests that losses hit us far harder and generate more emotional duress than a same-sized gain provides us joy. In other words, there is a greater emotional impact from losses than from an equivalent gain. The chart below from Investopedia illustrates this concept nicely.

Highlighted in this example, we can see that according to prospect theory, $50 loss causes us noticeably more emotional pain than an equivalent $50 gain brings us joy. Behavioral economists, including Nobel Prize-winner Richard Thaler generally estimate that we tend to feel the pain of a loss twice as severely as we enjoy a same-sized gain.

As a fun exercise, I thought I’d apply this concept to investors and the frequency with which they check on the value of their stock investments to demonstrate how maintaining a longer-term perspective can greatly improve an investor’s emotional well-being…at least as it relates to their financial lives!

For starters, consider the historical returns of the S&P 500 Index. According to data from Dimensional Fund Advisors, over the 69-year period than began in January 1950 and concluded in December 2018, the S&P 500 averaged an annualized gain of 11.1% per year. As we all know, however, the average is just that—an average. During this time period, the ride for stock investors was anything but a smooth, upward path as the market has gyrated up and down over the days, months, quarters and years. Thus, while stocks have historically delivered fantastic long-term returns and have been among the—if not the—best vehicle for long-term wealth generation, volatility has been an unavoidable part of stock investing.

Consider now, a hypothetical investor Vigilant Vince who, as his name suggests, vigilantly watches the daily moves of the market and his portfolio balance. During this same 1950 through 2018 period, based on data from Yahoo Finance, our hypothetical Vince would have experienced joy with the ringing of the closing bell on 54% of the trading days as the market closed higher. However along with his daily joys, Vince would have felt pain with the ringing of the bell 46% of the time as the market closed lower for the day.

We can use this data along with the lessons learned from prospect theory, to create a hypothetical index or measure to quantify Vince’s joy and pain in what I’ll call our emotional net joy/pain index. We’ll assume that Vince is similar to other people who experience the pain from losses twice as severely as they experience the joy from gains.

Vince’s net joy/pain index is crafted by summing the product of the frequency of positive daily return observations multiplied by one with the frequency of negative daily return observations multiplied by negative two (to account for losses hurting twice and much as gains bring joy). Accordingly, Vigilant Vince’s net joy/pain index will be (54% gains X 1) + (46% losses X -2) =    –39. One way to interpret this is that despite the S&P 500 Index gaining more than 11% on average per year over the 69-year period, Vigilant Vince was cumulatively in a state of emotional angst owing to his constant, daily market watching.

Now, let’s consider a second hypothetical investor, Annual Alice. Rather than watching the markets and checking her account balance daily like Vince, Alice, as her name suggests, just in the performance of her stock investments far less frequently and when she does, she prefers to focus on one-year or annual returns.

As the chart below shows, historically, the S&P 500 Index has delivered positive returns in 79% of rolling one-year periods from 1950 through 2018. Accordingly, Alice is nearly 50% more likely to observe positive returns than was Vince. Alice’s net joy/pain index, constructed in the same fashion as Vince’s, is +37, which represents a marked improvement.

Lastly, I’ll introduce one final hypothetical investor, Long-Term Larry, who, quite predictably based on his name favored taking a long-term view of his investment performance. Instead of focusing on daily performance like Vince or even annual performance like Alice, Larry only cares about how his stock investments have performed over the prior decade.

The chart above revealed that the S&P 500 Index delivered positive returns in 97% of its rolling ten-year periods from 1950 through 2018. As such, Larry’s net emotional joy/pain index clocked in at +90 indicating that despite receiving the same long-term returns as both Vince and Alice over the full 69-year period, he experienced a significantly more emotionally enjoyable journey by virtue of his long-term orientation and focus and willingness to allow the markets to work for him over the long haul.

I’ll wrap things up by plotting below the net emotional joy/pain indexes for all of the observation frequencies which were presented earlier. The chart clearly demonstrates that our hypothetical net joy/pain index increases dramatically as the observation horizon increases. This finding strongly suggests that maintaining a long-term focus and perspective is a potentially highly effective strategy for reducing the emotional stress that often accompanies stock market investing for many investors.

These findings bring to mind one of my favorite Warren Buffett quotes: “Benign neglect, bordering on sloth, remains the hallmark of our investment process.”

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

No strategy assures success or protects against loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

All investing involves risk including loss of principal.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.

INDEX DESCRIPTIONS

Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a Registered Investment Advisor. Private Advisor Group and Kathmere Capital Management are separate entities from LPL Financial.